Cervino Capital Management LLC

Open Letter Re: MF Global Bankruptcy

2012-01-12T17:59:00.000-08:00

To our clients and industry colleagues,

Let us begin by saying that Cervino Capital greatly values your business. We have always strived to put capital preservation and risk management at the forefront of our trading and operational activities.

As you know, on October 31, 2011 MF Global—one of the FCMs though which we cleared many of our client accounts—filed for bankruptcy. Subsequently, it came to light that “sacrosanct” rules, which specifically required client funds to be segregated from the firm’s assets, were not properly followed.

See: http://www.cftc.gov/PressRoom/PressReleases/pr6140-11
See: http://www.cftc.gov/PressRoom/SpeechesTestimony/opasommers-18
See: http://dealbook.nytimes.com/2011/12/28/mf-global-scrutinized-on-moving-of-money/

We empathize with everyone affected by the travesty that has unfolded at MF Global since the end of October, and note that we too were personally impacted by this situation.

On November 22, 2011 we took action by being the first to file a class action lawsuit against Jon S. Corzine and other senior executives at MF Global Holdings Ltd. The case is Accomazzo v. Corzine, 11-CV-8467, U.S. District Court, Southern District of New York. The case is being consolidated with other cases under a single U.S. District Judge, but our attorneys are moving to lead the sub-class on behalf of futures customers.

See: http://www.businessweek.com/news/2011-11-23/jon-corzine-sued-by-mf-global-customer-over-client-assets.html

As a sign of our commitment to our customers, Cervino Capital has decided to waive Q4 2011 fees for clients who were clearing their account at MF Global at the time of the bankruptcy, and who as a result suspended trading. Cervino Capital is respectful of the fact that this has been a painful period for MF Global customers and hope our gesture in a small way eases the burden.

Should you have any questions, please do not hesitate to contact us. In the meantime, we will continue to do what is in our power to ease the frustrations of our clients and business partners.

Very truly yours,

Michael “Mack” Frankfurter, Managing Director
Davide Accomazzo, Managing Director

2012 Outlook: Getting Back to Basics...

2012-01-12T17:52:00.000-08:00

1st Qtr 2011 Review and Black Swan Events

2011-04-10T12:55:00.000-07:00

Managed Futures: Is It an Asset Class?

2011-04-10T12:38:00.000-07:00

For those unfamiliar with the term managed futures, it is a niche sector of alternative investments that evolved out of the Commodity Futures Trading Commission Act of 1974, and refers to professionally managed assets in the commodity and financial futures markets. Management is facilitated by either Commodity Trading Advisors (CTAs) or Commodity Pool Operators (CPOs) who are regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Managed futures is the little kid brother to the hedge fund juggernaut. Even so, its impact upon the industry is writ large in two significant and related ways: first, managed futures unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve. Interestingly, the institutionalization of alternative investments can be traced back to the development of managed futures performance tracking databases first established around 1979. This data became the basis for an academic body of research on managed futures beginning with the seminal study by Harvard Business School professor, Dr. John E. Lintner.

So is managed futures an asset class? Let’s cut to the chase… in this writer’s humble opinion the answer is no, absolutely not. Well, maybe we would reconsider if managed futures was confined to just commodity interests, but with futures contracts also trading on financials, managed futures is as much an asset class as are registered investment advisers, mutual funds or hedge funds.

Lee, Malek, Nash and Rose (2006), on the other hand, would beg to differ. Their paper The Beta of Managed Futures makes the case that the predominant strategy in this space is trend following, and thus an appropriate benchmark for managed futures is one that mechanically mimics trend following systems. To say the least, it’s an interesting approach, and one which addresses issues related to peer group analysis and indices based on a composite of individual CTA programs. As Lee, Malek, Nash and Rose posit, “CTA indices represent the result of investing in CTAs, not the results of investing like CTAs.”

The weak part of their thesis, however, has to do with the assumption that managed futures essentially represents just trend following strategies. Lee, Malek, Nash and Rose readily admit that CTAs “employ a wide range of methods” and that such methods are “by no means exhaustive,” and include “breakout systems, systems based on moving averages and systems based on pattern recognition”. They attempt to reconcile this issue by creating a “beta benchmark” that “consists of twenty systems trading the world’s most liquid… markets”. According to their study, they found that their benchmark, for the period analyzed, was highly correlated to large CTAs.

That said, a mechanical trading index approach still leaves questions, including the validity of the trading methods utilized and the robustness of the parameters used to supposedly define the “beta of managed futures”. At a more subtle level, questions are raised by a relatively new concept proposed by Lo (2004) called the Adaptive Markets Hypothesis (AMH). AMH is based on an evolutionary approach to economic interactions and builds on the research of Wilson (1975), Lo (1999) and Farmer (2002) in applying the principles of competition, reproduction and natural selection.

In light of AMH, the paper by Lawrence Harris, The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity provides an intellectually honest answer as to the true dynamics underlying managed futures.

The following is from the paper’s abstract; written in 1993, it is not something you’d likely see in an academic paper nowadays: “Trading is a zero-sum game when measured relative to underlying fundamental values. No trader can profit without another trader losing. People trade because they obtain external benefits from trading… Three groups of stylized characteristic traders are examined. Winning traders trade for profit. Utilitarian traders trade because their external benefits of trading are greater than their losses. Futile traders expect to profit but for a variety of reasons their expectation are not realized.”

Harris goes on to discuss the obvious but little acknowledged fact that, “Trading performance reflects a combination of skill and luck. Successful traders may be skilled traders or simply lucky unskilled traders. Likewise, unsuccessful traders may be unskilled traders or unlucky skilled traders... We would like to believe that skill accounts for most variation in past performance among traders and managers,” but “from past performance alone, you cannot confidently determine who is skilled and who is lucky.” Therein lies the conundrum and the alternative investment industry's dirty little secret.

From this 20,000 foot level, the paper drills down and “examines the economics that determine who wins and who loses when trading.” Harris considers “the styles of value-motivated traders, inside informed traders, headline traders, event study traders, dealers, market-makers, specialists, scalpers, day traders, upstairs position traders, block facilitators, market data monitors, electronic proprietary traders, quote-matchers, front-runners, technical traders, chartists, momentum traders, contrarians, pure arbitrageurs, statistical arbitrageurs, pairs traders, risk arbitrageurs, bluffers, ‘pure’ traders, noise traders, hedgers, uninformed investors, indexers, pseudo-informed traders, fledglings and gamblers.” The paper goes on to “describe each of these traders, explain how their trading generates profits or losses, and consider how they affect price efficiency and liquidity.”

Because this paper was written in the early 1990s some of the descriptions may admittedly be dated relative to technological and quantitative developments in the field of trading since. Nevertheless, Winner and Losers of the Zero-Sum Game is a little noticed gem of a working paper whose astute observations ring true even today despite the escalating arms race in academic working papers being spun out of the university-industry revolving door.

Then why is managed futures constantly referred to as an asset class? Answer: out of laziness. However, such laziness goes beyond just the financial industry’s responsibility; truth is, half the problem lies with investors themselves—try as one might to delineate sophisticated investment concepts, the most common reaction is investors’ eyes glazing over.

So if managed futures is not an asset class, then what is it? As with many of the acronyms and lingo that the financial industry regularly comes up with, mainly for marketing reasons, the term has become a misnomer. What started out as an investment activity that was defined by regulations is now conventionally considered by many an asset class. C'est la vie…

- Mack Frankfurter, Managing Director

Winners and Losers of the Zero-Sum Game - Harris

References:
Harris, Lawrence. “The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity” School of Business Administration, University of Southern California, Draft 0.911, May 7, 1993.

Lee, Timothy C.; Malek, Marc H.; Nash, Jeffrey T.; and Rose, Jeffrey M. “The Beta of Managed Futures,” Conquest Capital Group LLC, February 2006.

Lintner, John E. “The Potential Role of Managed Commodity—Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds” Presented at the Annual Conference of the Financial Analysts Federation, May 1983.

Lo, Andrew W. “The Adaptive Markets Hypothesis; Market efficiency from an evolutionary perspective” The Journal of Portfolio Management, 30th Anniversary Issue 2004, pp. 15-29.

2010 Year End Thoughts and Economic Politics

2011-01-09T17:07:00.000-08:00

Alpha, Beta and Heisenberg Uncertainty

2011-01-09T16:56:00.000-08:00

In physics, complementarity is a basic principle of quantum theory closely identified with the Copenhagen interpretation, and refers to effects such as “wave–particle duality,” in which different measurements made on a system reveal it to have either particle-like or wave-like properties.

Niels Bohr is usually associated with this concept, which he developed at Copenhagen with Heisenberg, as a philosophical adjunct to the recently developed mathematics of quantum mechanics and in particular the Heisenberg uncertainty principle. The Heisenberg uncertainty principle states that certain pairs of physical properties, like position and momentum, cannot both be known with precision. That is, the more precisely one property is known, the less precisely the other property can be known.

In Chinese philosophy, the concept of “yīn yang” is used to describe how polar or seemingly contrary forces are interconnected and interdependent in the natural world, and how they give rise to each other in turn. Yin yang are complementary opposites within a greater whole. Everything has both yin and yang aspects, although yin or yang elements may manifest more strongly in different objects or at different times. Yin yang constantly interacts, never existing in absolute stasis as symbolized by the Taijitu symbol.

A similar paradox exists within the CAPM paradigm involving the relationship between the concept of "beta," as determined by the market portfolio, and "alpha," which loosely represents "a proxy for manager skill". As suggested by our blog, "The CAPM Debate and the Search for 'True Beta'", the yin yang “whole” relates to the “True Beta” concept which Jagannathan and Wang (1996) theorized must encompass “the aggregate wealth portfolio of all agents in the economy”.

Schneeweis (1999) in his article, “Alpha, Alpha, Whose got the Alpha?,” writes about a related problem with respect to measuring “alpha” by raising the question of “how to define the expected risk of the manager’s investment position”. In other words, when marketing “alpha” portfolio managers often assume “the reference benchmark is the appropriate benchmark and that the strategy has the same leverage as the benchmark”. Further, “[w]ith the exception of a strategy that is designed to replicate the returns of the benchmark, the alpha generated by this approach is essentially meaningless”.

Schneeweis (1999) makes the case that investors often make the mistake of relying on a single-index model as a meaningful benchmark from which to gauge the factors “driving the return of the strategy” when often a “multi-factor model should be used to describe the various market factors that drive the return strategy”. The problem is that statistically it is “better to over-specify a model… than to under-specify. If the model is over-specified, many of the betas will simply be zero. However, if under-specified, there is the possibility of significant bias”.

Which brings us back to the Heisenberg uncertainty principle...

Just like the physical properties of position and momentum cannot both be known with precision, the properties of “alpha” and “beta” can also not be measured precisely. This statement has been interpreted in two different ways. According to Heisenberg its meaning is that it is impossible to determine simultaneously both properties with any great degree of accuracy or certainty. According Ballentine this is not a statement about the limitations of a researcher's ability to measure particular quantities of a system, but it is a statement about the nature of the system itself as described by the equations.

- Mack Frankfurter, Managing Director

Alpha Alpha Whose Got the Alpha - Schneeweis

References:
Schneeweis, Thomas. “Alpha, Alpha, Whose got the Alpha?” University of Massachusetts, School of Management (October 5, 1999).

Jagannathan, Ravi; McGrattan, Ellen R. (1995). “The CAPM Debate” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 19, No. 4, Fall 1995, pp. 2-17.

Bohr, Niels. Atomic Physics andHuman Knowledge, p. 38.

Heisenberg, W. Über den anschaulichen Inhalt der quantentheoretischen Kinematik und Mechanik. In: Zeitschrift für Physik. 43 1927, S. 172–198.

Ballentine, L.E. The statistical interpretation of quantum mechanics, Rev. Mod. Phys. 42, 358–381 (1970).

3rd Qtr 2010 Review and Currency Wars

2010-10-12T03:42:00.000-07:00

Reversing the Model’s Line of Causation

2010-10-12T03:35:00.000-07:00

The 1970s was a crucial turning point in the history of 20th century gold markets. The costs of the Vietnam War and increased domestic spending had the effect of accelerating inflation. Meanwhile, US gold stock declined to $10 billion versus outstanding foreign dollar holdings estimated at about $80 billion.[1] Prior to that, the London Gold Pool made up of seven European central banks and the US Federal Reserve, a group which cooperated in maintaining the Bretton Woods System, found itself increasingly unable to balance the outflow of gold reserves and defend the fixed gold price of US$35.[2]

On August 15, 1971, President Nixon, a self-proclaimed Republican “conservative,”[3] imposed a 90-day wage and price control program and other various expansionary fiscal policies in what became known as the “Nixon Shock”[4]. Most importantly, Nixon closed the gold window to prevent foreign governments that had been holding dollar-denominated financial assets from demanding gold in exchange for their dollars. By March 1973, all of the major world currencies were floating and in November 1975, the G-7 (i.e, Group of Seven) formed to hammer out the final details on a framework for a new monetary system. That agreement, which was finalized in January 1976, called for an end to the role of gold, the establishment of SDRs as the principal reserve asset, and legitimized the de facto system of fiat currencies and floating exchange rates.

The reason for retelling this story is because these events, along with a collapse in gold prices after peaking on January 21, 1980 at the high price of $850, led directly to formation of the gold leasing market during the mid-1980s. Gold loans evolved as a means for central banks to earn a return on their bullion inventories to cover the cost of warehousing bullion[5][6] by either leasing or swapping[7] gold in exchange for a lease rate. This rate is derived from the difference between the LIBOR and Gold Forward Offered (GOFO) rate.

A leasing transaction involves a central bank transferring ownership to a leasing institution (i.e., borrower), who could then sell the gold on the spot market and invest the proceeds. At a later date, the borrower would buy back the gold and return it to the central bank while paying the lease rate. Because gold could be leased at a relatively low rate from the central bank and then sold quickly on the spot market, participants in this market included gold producers who thereby gained cash to finance gold production at a comparatively low rate of interest, while simultaneously hedging against falling gold prices.[8]

The market for gold loans developed quickly after the October 1987 stock market crash left many mining companies with reduced access to capital. Prior to 1990, GOFO rates for gold normally were below 2 percent on an annualized basis and never exceeded 3 percent, providing an inexpensive source of finance for mining companies.[9] The Financial Times reported that some 30 central banks were estimated to have engaged in gold loans around this time.[10] Then in 1990 Drexel Burnham Lambert collapsed with large outstanding gold liabilities to many central banks, resulting in increased wariness and reduced supply of gold loans from central banks.[11] As a result, lease rates rose reflecting an increased tightness in the market after the loss of central bank suppliers, as well as a substantial risk premium over the implicit cost of providing such loans.

Nevertheless, the market for gold loans grew throughout the 1990s, and an informal global interbank system developed permitting dealers to borrow gold on a short-term basis in order to fulfill delivery requirements. When bullion subsequently dropped below $300 an ounce in late 1997, and drifted in that range through 2002 in what is now referred to as the “Brown Bottom,”[12] the gold carry trade came to dominate the derivatives markets. Gold’s steady appreciation since 2002, however, has rendered this trade obsolete. As a result, there has been a wholesale transformation in the gold market since the millennium began.

In a research paper published by the Swiss Finance Institute (SFI) titled, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market, the authors examine this aspect of the gold market in detail. They too note that, “…since late 2001, the profitability of the carry trade has diminished. Rising gold prices have increased risk and diminished the trade’s profitability as a result of increasing repayment costs. Consequently, the prevalence of the gold carry trade is predicated on two factors: the rate at which the central bank is willing to swap or lease gold, and whether or not the gold price is increasing.” Further, the authors Barone-Adesi, Geman and Theal (2009) observe that the COMEX “is witnessing historically low derived lease rates, decreasing hedging activity and steadily rising non-commercial open interest.”

The reason why is because the gold carry trade is risky on two dimensions. First, if the borrower invests in long-term bonds, rising interest rates could cause downward pressure on bond prices exposing the leasing institution to principal risk. Second, since the borrower is effectively short gold, if the loan is called by the central bank and gold has risen in value, they may have to purchase gold at a higher price in the spot market. Hence, there always exists the potential of driving up gold prices even higher due to short covering. This unwinding of the carry trade, as with other similar trades (e.g., yen carry trade), can result in volatile markets.

The question then is to what extent is speculation having a “tangible effect” on gold valuations, and “if so, by what mechanism does speculation influence prices?” The SFI paper points out other academics, such as Kocagil (1997), who defined “speculative intensity” as the “spread between the futures and expected spot price,” and concluded that “speculation increases spot price volatility and thus has a destabilizing effect on price.” Another researcher, Abken (1980), based his analysis on the intuition that the only return that gold yields is based on the anticipated appreciation of gold above “any marginal costs associated with the storage of gold.” Abken further argues that, “during times of uncertainty, excess demand for gold as a store of value [drives] up the spot price causing stored gold to be brought to market.”

The authors of the SFI paper, on the other hand, base part of their methodology on the work of Houthakker (1957), one of the first researchers to use trader commitment data to study speculation. To understand how speculative agents can affect the gold futures market, Barone-Adesi et al. (2009) examine the open interest data from the CFTC Commitment of Traders (CoT) report, thereby identifying commercial open interest with hedging activity, and conversely, non-commercial positions with speculative activity. The authors also study the relationship between gold leasing and the level of COMEX discretionary inventory.

Not surprisingly, Barone-Adesi et al. (2009) arrive at obvious conclusions: First, they note an ever-increasing percentage of non-commercial open interest reflects increased speculation in the gold market. Second, “the lease rate and the speculative pressure appear to work in opposition to one another; the former acts to decrease short-term bullion inventories via lease repayments, while the latter result suggests speculators dominate leasing activity in the long term… Finally, the presence of speculation in gold futures contracts can be associated with increased futures contract returns and that this effect increases with increased futures contract maturity.” What these observations suggest in their entirety is that “speculation plays a significant role in the COMEX gold futures market” as opposed to hedging activities.

Uh, okay… but isn’t this a foregone conclusion? Albeit, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market derives its determinations from some interesting theoretical ideas between the relationship of gold loans, bullion inventories, convenience yield and speculation; but in the final analysis the SFI paper raises the specter of Muth’s (1961) Rational Expectations and the Theory of Price Movements: “In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory.”

In other words, models unfortunately have the bad habit of assuming a predetermined conclusion around which expectations are formed, which in effect reverses the model’s line of causation. Our conclusion: research bias, the process where the scientists performing the research influence the results in order to portray a certain outcome, seems to be at work here—even though we happen to agree with such paper’s conclusions.

- Mack Frankfurter, Managing Director

On the Lease Rate and Convenience Yield of Gold Futures

Footnotes:
[1] Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

[2] Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

[3] Nixon tape conversation No. 607-11.

[4] “The Economy: Changing the World's Money” Time Magazine, Oct. 4, 1971 [First reference by Time of “Nixon Shock”]; http://www.time.com/time/magazine/article/0,9171,905418,00.html

[5] “Bullish on Bullion” by Peter Madigan, Risk Magazine, Feb. 1, 2008, Incisive Media Ltd.

[6] According to O’Callaghan, Gary (1991), two key disadvantages in holding gold as opposed to a financial instrument are storage costs and the fact that holding gold does not bear interest.

[7] A gold swap is essentially a transaction whereby gold is exchanged for currency.

[8] O’Callaghan, Gary (1991). The Structure and Operation of the World Gold Market. International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525, p 33.

[9] Ibid. pp 33-34.

[10] Gooding, Kenneth, “Gold Lending Rate at Record Level,” Financial Times (London), Dec. 4, 1990, p 34.

[11] “Fool’s Gold,” The Economist, Mar. 17, 1990, p 79.

[12] Term used to describe the period between 1999 and 2002, named from the decision of Gordon Brown, then the UK's Chancellor of the Exchequer to sell half of the UK's gold reserves in a series of auctions.

References:
Barone-Adesi, Giovanni, Geman, Hélyette and Theal, John (2009). “On the Lease Rate, the Convenience Yield and Speculative Effects in the Gold Futures Market” (March 12, 2009). Swiss Finance Institute Research Paper No. 09-07.

Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

O’Callaghan, Gary (1991). “The Structure and Operation of the World Gold Market” International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525

Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

1st Qtr 2010 Review and Imploded Volatility

2010-04-07T11:58:00.000-07:00

Hamilton and Minsky's Instability Hypothesis

2010-04-07T11:34:00.000-07:00

"Men often oppose a thing merely because they have had no agency in planning it, or because it may have been planned by those whom they dislike." ~Alexander Hamilton

Almost exactly two hundred years before Hyman Minsky published his paper The Financial Instability Hypothesis in 1992 (the relevance which will become apparent), a blind pool[1] known as the “six percent club” was engaged in the first market corner in the history of the United States. According to traditional accounts,[2] the Panic of 1792 was caused by the scheming and operations of William Duer, a well-connected businessman and speculator, who had recently resigned from his brief post as assistant secretary of the treasury of the newly formed country.

It all started when Treasury Secretary Alexander Hamilton put into action a plan to buy at par value the millions of dollars in promissory notes that the bankrupt Continental Congress and state governments had issued to soldiers, farmers, and other’s who had supported the Revolution. Duer, who combined government service with a passion for quick profits, leaked word to his fellow “grandees” that Hamilton intended to consolidate these debts with federal debt. Recognizing Hamilton’s plan as a way to make a killing, agents of Duer’s secret circle were soon galloping across the countryside buying up state paper at a few cents on the dollar.[3]

As a homily to the present-day bailout of the financial system wherein information asymmetry has become a recurrent headline about the markets,[4] Duer’s anecdote has some interesting parallels were it to end here. This brief episode, however, set in motion a series of events which ultimately led Hamilton to invent what in time would be termed Bagehot’s rules[5] for how a central bank should act in a crisis some [eight] decades before Walter Bagehot “rediscovered” them.[6]

In December 1790, Congress adopted Hamilton’s recommendations.[7] Old evidences of debt were already being exchanged for new federal debt in the form of 6% bonds, 6% deferred bonds and 3% bonds starting in October 1790.[8] These bonds were soon trading on America’s first “stock” exchange under a buttonwood tree at the foot of Wall Street. Hence, it was these very same events which presaged the origins of the New York Stock Exchange when twenty-four New York City stockbrokers and merchants signed the Buttonwood Agreement in 1792.

Around this time Hamilton had also called for Congress to incorporate a Bank of the United States capitalized with 25,000 shares of $400 par value each.[8] Noting that speculation was already brisk in federal 6% notes, Hamilton attempted to check a similar fever in the Bank’s stock by requiring $100 in specie[9] along with $300 in new United States debt securities. However, “Congress, already demonstrating an eagerness to please as many people as possible,” reduced the opening payment to $25 for a scrip”[10] which effectively served as a subscription right.

The initial offering took place on July 4, 1791 and was heavily oversubscribed. In five weeks the value of scrip soared reaching 264 bid-280 ask in New York and more than 300 in Philadelphia before tumbling. The so-called “U.S. sixes” rose from 90 at the time of the Bank’s offering to 112.50 on August 13th before falling to 100 by August 17th. In response, Hamilton convened a meeting of the Commissioners of the Sinking Fund which authorized open market purchases of U.S. debt. Working through various agents, Hamilton restored confidence by supporting the bond market.[8]

It turns out that the mini-panic of August 1791 served as “a trial run for the crisis-containment techniques Hamilton was to employ during the more serious price collapse in March-April 1792.”[8] In fact, Hamilton’s actions in 1791 illustrate the mixed blessings of crisis management in that his response may have encouraged the speculative bubble that followed. Almost two centuries later Alan Greenspan responded similarly to the stock market crash of 1987 as well as subsequent crisis during his tenure. As been argued, by coming to the aid of the market and creating the notion of a “Greenspan put,” the moral-hazard problem may have sowed the seeds of our current crisis.

This is where Minsky enters the picture. A little over a decade ago, the term “Minsky moment” was coined to describe the Russian debt crisis in 1998 which proceeded the fall of Long Term Capital Management. Minsky observed “that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control.” The Minsky moment occurs after a long period of prosperity in which debt is increasingly used to finance investments, in turn causing the value of assets to rise, which reflexively encourages speculation using borrowed money. At the point when investors’ cash flow no longer supports debt, a major selloff begins leading to a precipitous collapse in asset prices and market liquidity.

Theoretically, one could link the current financial crisis to a Minsky moment caused by the failure of two Bear Stearns hedge funds circa June 2007 resulting in the “reverse Minsky journey”.[11] The irony is hard not to miss in the following passage of Minsky’s paper:

Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities… For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts... Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts. [Bold added]

As Minsky points out, if authorities attempt to exorcise monetary constraint in “an economy with a sizeable body of speculative financial units… then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate.” Notwithstanding the obvious inference to the Madoff affair, the Oracle of Omaha, Warren Buffet, concisely summarized that, “Only when the tide goes out do you discover who's been swimming naked.”

The common factor distinguishing the difference between Minsky’s hedge, speculative, and Ponzi finance units is liquidity. Liquidity is conventionally defined as, “the ability of an asset to be converted into cash quickly and without any price discount”.[12] It has been said that the root of the current liquidity crisis is a lack of confidence—confidence basically disappeared and liquidity evaporated. But this behavioral observation is both simplistic and obscures turnkey concepts.

The exchange of money involves a valid and legal offer of payment for debts when tendered to a creditor. A debtor who is unable or unwilling to meet the legal obligations of a debt contract by not making a scheduled payment is said to have defaulted. In a very narrow sense, legal tender is a form of payment that, by law, functions in the settlement and discharge of debt. “There is, however, no Federal statute mandating [a person] must accept currency or coins as for payment for goods and/or services.”[13] A case study in non-payment is the recent default by debtor Tishman Speyer Properties on the Peter Cooper Village and Stuyvesant Town complex in Manhattan.

In 2006, Tishman Speyer headed a venture to acquire the 11,000 unit property for $5.4 billion—the most ever paid for a residential property in the U.S. Of that price tag, Tishman Speyer only invested $168 million; however, CalPERS, Church of England, Hartford Financial and even the Government of Singapore are in danger of having their investments wiped out. The venture’s acquisition was controversial to begin with as plans were to raise rents in the middle-class haven. The strategy backfired because of the economy and a court ruling which prevented conversion of rent-controlled units to market rates. As a result, the property depleted what was left in its reserve funds.[14] Tishman Speyer, having been closed out of the capital markets, essentially faced a liquidity crisis from a levered deal which could not be supported by the property’s revenues from rentals.

William Duer also faced a liquidity issue in March of 1792. After Hamilton intervened in 1791 by purchasing “U.S. sixes,” confidence was quickly restored. However, rather than learning his lesson, Duer and other members of his speculative “company” borrowed large amounts of money and rapidly drove up securities prices during the latter half of 1791. When Duer finally defaulted in 1792, it caused a contagion of defaults and panic selling. In response, Hamilton began “a series of lender-of-last resort operations that would last for several weeks as the panic went on”.[8]

- Mack Frankfurter, Managing Director

References:
Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.

Fleming, Thomas (2009). “Wall Street’s First Collapse.” American Heritage Magazine, Volume 58, Issue 6.

Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life.” Harper Perennial.

Lahart, Justin (2007). “In Time of Tumult, Obscure Economist Gains Currency.” WSJ (August 18, 2007).

Madison, James. “The Federalist No. 44, Restrictions on the Authority of Several States.” (Jan. 25, 1788).

Markham, Jerry W. (2001). “A financial history of the United States.” Armonk, N.Y.: M.E. Sharpe.

McCulley, Paul (2007). “A Reverse Minsky Journey.” October 2007. http://tinyurl.com/2sbogw

Minsky, Hyman P. (1992). “The Financial Instability Hypothesis.” Working Paper No. 74, The Jerome Levy Economics Institute of Bard College, Prepared for Handbook of Radical Political Economy, edited by Phylip Arestis and Malcolm Sawyer, Edward Elgar: Adershot, 1993.

Footnotes:
[1] A “blind pool” is an investment vehicle that raises capital from the public without telling investors how their funds will be utilized.

[2] According to Cowen, Sylla and Wright (2006), “Although specialists in financial history have known of the 1792 panic for decades, at least since Davis (1917) explored it in some detail, it did not make a strong impression on others.” Further, “The traditional account is not incorrect, but it is incomplete. Other events were unfolding at the time that are ignored or slighted in the traditional account.”

[3] Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6. See also: Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life,” HarperCollins.

[4] Information asymmetry encompasses “insider trading” (eg, indictment of Galleon Group founder Raj Rajaratnam); and “front-running” (eg, trading ahead of customer orders, trading ahead of research reports, etc.)

[5] “[T]o avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at ‘high rates.’” Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.

[6] Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.

[7] Knowledge that the new federal bonds could also be used at par to subscribe for three-fourths of the cost of a share in the Bank of the United States was officially made public in the Bank Report of December 13, 1790.

[8] Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.

[9] Latin phrase. It is used to indicate that distribution of an asset will be “in its actual form,” rather than cash.

[10] Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6.

[11] Term “reverse Minsky journey” is attributable to Paul McCulley of PIMCO, “A Reverse Minsky Journey,” October 2007. http://tinyurl.com/2sbogw

[12] “Glossary of Terms”, Federal Reserve Bank of St. Louis, September 2009

[13] U.S. Department of Treasury, http://tinyurl.com/36suqq

[14] Wei, Lingling and Spector, Mike. “Tishman Venture Gives Up Stuyvesant Project,” WSJ (January 25, 2010).

2009 Year End Thoughts and Policy Risks

2010-01-04T15:38:00.000-08:00

It's the End of the World As We Know It

2010-01-04T14:43:00.000-08:00

Marcellus: Something is rotten in the state of Denmark.
--William Shakespeare, Hamlet Act 1, scene 4

In the 1950s, Leon Festinger and two others infiltrated a UFO doomsday cult that was expecting the imminent end of the world on a certain date, and documented the increased proselytization they exhibited after the leader’s “end of the world” prophecy failed to come true. The prediction of the Earth's destruction, supposedly sent by aliens to the leader of the group, became a disconfirmed expectancy that caused dissonance between the cognitions, “the world is going to end” and “the world did not end”. Although some members abandoned the group when the prophecy failed, most of the members lessened their dissonance by accepting a new belief—that the planet was spared because of the faith of the group.

The economic crisis of the last two years provides a haunting corollary to Festinger’s study. In an interview on CSPAN on January 27, 2009, House Representative Paul Kanjorski defended the original emergency actions by the United States government to halt the financial crisis. Kanjorski stated that the move to raise the guarantee money funds up to $250,000 was an emergency measure to stave off a massive “electronic run” on money markets that removed $550 billion from the system in a matter of hours on the morning of September 18, 2008. He further asserted that, if not stopped, the run would not only have caused the American economy to crash immediately, within 24 hours it would have brought down the world economy as well.

As the “end of the world” did not come to pass, there are those who question Kanjorski’s account such as Felix Salmon of Condé Nast Portfolio; although financial writer Daniel Gross confirmed some elements of the story, but prefaced his remarks by saying “I don’t know if his numbers are 100 percent correct”. Such criticism raises the question of how we prejudice “fact” from “truthiness” in the so-called "soft science" of economics, which in turn leads to questions about the assumptions underlying economic models. Joseph Stiglitz, the Nobel Prize-winning economist and Columbia University professor, stated that economists are among those at fault for the financial crisis, which exposed “major flaws” in prevailing ideas. The now-flawed premises include the ideas that economic participants behave rationally and that financial markets are competitive and efficient. In a damning remark, Stiglitz claimed that “Globalization had opened up a global marketplace for fools.”

What the world economy now faces is cognitive dissonance on a global basis. The conundrum with respect to cognitive bias is that implicit in the concept is the standard of comparison. In other words, peel the onion and we’re left with the unsettling question as to which denomination do we use to value assets. Relativity, it seems, goes to the very heart of the inflation versus deflation debate. Are investors making rational decisions as a result of the currency in which they form their perspective of valuation? In a world in which the US dollar is no longer the world’s reserve currency, what substitutes as safehaven in a “flight to quality”?

The question of how banks manage their collateral deals with other financial players is usually not of interest to ordinary investors. Until recently, the widely held assumption that the credit standing of European countries and the US was secure resulted in banks not demanding collateral when sovereign entities are involved. Similarly, when banks made loans to western sovereign nations, they typically do not post big reserves since such debt is deemed “zero-risk weighted” in bank regulatory rules. However, as a result of seemingly remote events, or “tail risks” having come to fruition these past two years, debt default in a developed country is no longer unthinkable. In fact, once upon a time even the US repudiated its debt in 1933 by outlawing the private ownership of gold, and requiring creditors to be paid in “legal tender coin or currency”.

The Triffin dilemma is the fundamental problem of the US dollar's role as the world’s reserve currency leading to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, particularly in the US current account. According to Martin Wolf, chief economics commentator of the Financial Times, the host nation of a global reserve currency will inevitably run up a huge current account deficit that undermines the credibility of its currency and adversely impact the global economy. As it stands, the US currently has a national debt in excess of $12 trillion or almost $40,000 per citizen, with a debt to GDP ratio of more than 85 percent. “On the dollar, there is nothing to support this currency except the Chinese government and a few other governments that are prepared to buy it,” said Wolf at an event organized by the Singapore Institute of International Affairs.

More so, the perverse vendor-financing relationship between the Chinese renminbi and US dollar is highly destabilizing for the euro zone economy. The European Commission recently warned that public finances in half of the 16 euro-zone nations are at high risk of becoming unsustainable. Because there is little chance of European governments intervening in the foreign exchange markets to improve the competitiveness of the euro, American policy is effectively “shifting the recession from them(selves) to their trading partners,” according to Wolf. The decline of the US dollar underscores a phase of global power transition, with the balance of power moving from the US to Europe, China and India, Wolf argues, adding that the greenback’s loss of credibility as the dominant global reserve currency is part of this messy transition.

It is with this context in mind that one can begin to analyze the cognitive dissonance arising from the fundamental problem that the US cannot resolve this credit crisis by issuing more debt. Yet with the White House announcing that it had eliminated the maximum bailout cap for Fannie Mae and Freddie Mac on Christmas Eve, it seems that US policy-makers are finding yet another way to extend the process of quantitative easing. Such rule changes are the “tip of the spear” in a whole range of unprecedented policy actions which have hugely grown the monetary base in the hope that such action will “reflate” the economy. One likes to think that the US is a government-of-laws-not-men presiding over a level playing field, but in an effort to “save us from ourselves” it now seems that the US is constantly changing the rules anytime it wants. Unfortunately, such actions can only have the detrimental effect of undermining the moral standing of the US dollar long term. As the song says, “it’s the end of the world as we know, but I feel fine”.

- Mack Frankfurter, Managing Director

2nd Qtr 2009 Review and Recovery Debate

2009-07-06T12:27:00.000-07:00

Commodity “Roll Yield” a Fictional Return?

2009-07-06T12:07:00.000-07:00

This article, originally published by Opalesque Futures Intelligence (Issue 5, April 7, 2009), is an extract from the paper, “Term Structure and Roll Yield: Not Your Father’s Backwardation.”

Half the lies they tell about me aren't true. --Yogi Berra

Term Structure and Roll Yield
Question: if something is stated repeatedly as fact, does that make it necessarily true? We no longer believe the sun circles the earth, but that idea was once conventional wisdom.

A similar issue faces investors who use passive commodity indexes. In a recent Financial Times story, “Steep ‘contango’ forces traders to adapt commodities plans”, we are told that investors in commodity index products “obtain a separate return, known as the roll yield, as they shift their positions each month from the expiring futures contract into the following month.” This idea is so commonly asserted that it is accepted as fact—but is it?

The problem is that empirical tests using a variety of models have produced inconsistent conclusions as to whether there is in fact positive expected returns from speculating in the futures market. This is vexing to financial institutions who sell products structured around commodity benchmarks such as the S&P GSCI or DJ-AIG, and who need to “market” a structural source of return in what is essentially a zero-sum game.

Notably, ten years ago mainstream thinking about commodities was largely negative. Thomas Schneeweis and Richard Spurgin in their 1996 paper, “Multi-Factor Models in Managed Futures”, stated that the low level of investment in managed futures was due to the fact that investors required both a theoretical basis and supporting empirical results. In other words, prevailing wisdom at the time was against speculation in commodities.

The industry’s marketing solution came in the form of a series of studies over the past decade of which the most cited is “Facts and Fantasies about Commodity Futures” written by Gary B. Gorton and K. Geert Rouwenhorst, two Yale University academics. After their paper was referenced by Jim Rogers in his book Hot Commodities, the concept and theory of the roll yield became well established in the investor mindset.

Our working paper “Is Managed Futures an Asset Class; The Search for the Beta of Commodity Futures” nonetheless, takes issue with Gorton and Rouwenhorst’s conclusions.

To begin with, the roll yield is derived from a simplified definition of backwardation and contango based on what Hilary Till, co-editor of Intelligent Commodity Investing, describes as the “term structure of the futures price curve.” Nowadays, backwardation is commonly defined as conditions when “the futures price is below the current spot price” and contango as conditions when “the futures price is above the current spot price.”

However, this paradigm is not in line with the original definition of normal backwardation as described by John Maynard Keynes (1923, 1930), and related phenomena identified by Nicholas Kaldor (1939) and Holbrook Working (1948, 1949). Classically, backwardation and contango correlate the futures price to the “expected future spot price,” which is an unknown, to be discovered in the future, at the time the futures converges with the spot.

This difference in assumptions is not insignificant. The conundrum is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in forward contracts. They are simply agreements which commit delivery of an asset at some place/point in time. So how does rolling contracts yield positive expected returns?

Rolling the Futures Contract Backward
Futures and forward contracts, unlike securities, are instruments with a finite life and terminate on pre-specified dates when the futures contract converges with the spot price. At that point the spot price is discovered and delivery of the underlying cash commodity is made between commercial participants.

A wheat futures contract, for example, has delivery contracts for March, May, July, September and December. For this reason, and as a matter of practice, most speculators do not allow their positions to enter the delivery period, and a perpetual long futures position requires a trader to “roll the contract” from one contract month to the next.

A close look at the studies written by proponents of the roll yield reveals use of a model or algorithm that results in a fictional trade. Rather than rolling the futures contract forward, they in effect roll the futures contract backward to provide “proof” for their thesis. This is facilitated with the assumption that the “expected future spot price” is a pre-determined static constant, which it is not.

As a real world example, let’s assume that a trader goes long a March futures contract at $100. The trader subsequently rolls that contract in sixty days by selling it at $120, and simultaneously reenters the long position via a July futures contract at $121. Sixty days later the trader exits the position altogether by liquidating the July contract at $111.

The long March futures contract trade results in a $20 realized gain and the long July futures contract trade results in a $10 realized loss. Using a simple method for calculating rate-of-return of an investment, the net gain of $10 is divided into the original $100 March futures contract price, resulting in a 10% return. This is straightforward and logical.

By contrast, the model for calculating the roll yield is complicated and arguably illogical. The following example is based on formulas conventionally used by researchers to calculate roll yield as documented by Till (2007) in Intelligent Commodity Investing (chapter 3, pages 73-78).

Let’s assume a trader goes long a March futures contract at $100, and then sixty days later sells the March contract at $120. The net gain of $20 is then divided into the original investment of $100 resulting in a 20% return. This is referred to as the “spot return.”

Now at the time the trader purchased the March futures contract, assume that the July futures contract was trading at $90. The algorithm for calculating the roll yield then subtracts this $90 July futures contract price in the past from the current $120 March contract liquidation price. This is called “excess return” and the net gain of $30 is then divided into the $90 July contract price for a 33% return.[1]

The “arithmetic” roll yield is calculated by subtracting the spot return of 20% from the excess return of 33%, which results in a supposed 13% return to the investor. Obviously, this mathematical trick mixes up past and present prices, and creates roll yield out of an imaginary transaction that is impossible to duplicate in the real world.

Admittedly, models are an abstraction from reality. Expecting such models to be exactly right is unreasonable, and it is generally understood that neoclassical economic models have inherent limitations. Ergo, we must be careful not to follow models over a cliff.

As noted by Robert Greer in his paper What is an Asset Class, Anyway?, the inherent problem with investing in commodities as an “asset class” is that they are not capital assets but instead consumable, transformable [and perishable] assets with unique attributes.

By definition, any commodity trading facilitated for financial rather than commercial reasons is speculation. Further, derivatives are risk management tools, fundamentally different from the “rising tide raises all ships” concept of the capital formation markets.

Investors should recognize that commodity markets are more complex than what many proponents would have you believe. In truth, the “zero-sum conundrum” makes it impossible to isolate a persistent source of return without that source eventually slipping away.

----------------------------
COMMODITY RETURN SOURCES

* Spot Return - Gain or loss from changes in the underlying spot prices. When the spot price of the commodity rises, the value of the futures contract tends to rise.

* Collateral Return - Interest on the deposit required to trade derivatives.

* Strategy Return - Some analysts refer to a return derived from how one weights and rebalances the components of a commodity index.

* Roll Return (focus of article) - Generated by owning a futures contract for a time, and subsequently selling that contract and buying a longer dated contract on the same commodity.

[1] Hilary Till cites the following with respect to excess returns: “As explained by Shimko and Masters, the convention in calculating excess returns is to treat the futures investment as being fully collateralized based on the second-nearby price.” D. Shimko and B. Masters, 1994, “The JPMCI—A Commodity Benchmark.”

References
Keynes, John Maynard (1930). “A Treatise on Money, Volume II: The Applied Theory of Money” London: Macmillan, 1930, pp. 142-147.

Greer, Robert J. (1997). “What is an Asset Class, Anyway?” Journal of Portfolio Management, Winter, 86-91.

- Mack Frankfurter, Managing Director

1st Qtr 2009 Review and Shifting Outlooks

2009-05-12T17:21:00.000-07:00

Epilogue: In the Beginning There was Alpha

2009-05-12T13:04:00.000-07:00

Hear then, o Economidae, nymphs of the streams
Of infinitely discussed yet discounted prophets,
Of the story which I sing: the epic of men
And women locked in the battle of egos and coherence,
Precision and relevance, the song for all ages
And peoples to hear and revere the great and poor
Deeds of this tribe of malcontents and heroes...

--The Walrasiad, Prologue

Epilogue:

In the beginning, Man created the markets. The markets were without form and void, and darkness was over the faces of analysts. And Man said, “Let there be Alpha,” and there was Alpha. And Man saw that Alpha was skeptic. So Man created Beta from Alpha so that he may have faith. Thus it was that Beta evolved from the aggregate of individual Alpha decisions.

In time Man affirmed that Alpha is only a derivative of Beta and not unto itself. Thus it was Alpha’s fate to be banished to the farthest corners of the market where it thrived little noticed in the wilds of commodities and forex, and strange unknown strategies.

And so it came to be that Beta ruled the markets for many generations and organized itself around the concept of rational agents and equilibrium. And those who claimed to be Alpha were really leveraged Beta or Alpha corrupted by money flows into exotic Beta. And Man saw it was good.

But alas, Man was not happy in his greed and sought more leverage and converted evermore Alphas from the wilds with the trap of untold assets under management. And thus, Beta's down-fall did come about, as Man did not recognize that faith and greed is cause for disequilibrium. Soon the wisdom of crowds became the madness of crowds, and all was chaos in the markets.

This was the way of the markets when the few remaining Alphas, the true skeptics, whose only heresy was to saith that economic agents are irrational and the natural order of the markets is disequilibrium, returned from banishment and did cause great wealth for their kind.

Thus it was that “true” Alpha in its actions restored the equilibrium. From then on it was said by Man that Alpha seeks madness in the wisdom of crowds and wisdom in the madness of crowds.

Hence, price discovery is yin-yang, as is wave-particle duality. In truth, all Man's philosophies reveal this dichotomy as Man is trapped in the observer effect, prisoners of the box in which Schrodinger placed his cat. Ergo, the universe is akin to True Beta and just a huge mechanism for price discovery on a quantum level. And Man saw that creative destruction was good.

- Mack Frankfurter, Managing Director

2008 Year End Thoughts Going Into 2009

2008-12-22T18:45:00.000-08:00

Steamrolling Over Option Trading Programs

2008-12-22T17:55:00.000-08:00

[Originally published October 21, 2008 on SafeHaven and MarketOracle.]

"In days of old, seers entered a trance state and then informed anxious seekers what kind of mood the gods were in, and whether this was an auspicious time to begin a journey, get married, or start a war. The prophets of Israel repaired to the desert and then returned to announce whether Yahweh was feeling benevolent or wrathful. Today The Market's fickle will is clarified by daily reports from Wall Street and other sensory organs of finance. Thus we can learn on a day-to-day basis that The Market is "apprehensive," "relieved," "nervous," or even at times "jubilant." On the basis of this revelation awed adepts make critical decisions about whether to buy or sell. Like one of the devouring gods of old, The Market -- aptly embodied in a bull or a bear -- must be fed and kept happy under all circumstances. True, at times its appetite may seem excessive -- a $35 billion bailout here, a $50 billion one there -- but the alternative to assuaging its hunger is too terrible to contemplate."
--Dr. Harvey Cox, Atlantic Monthly (1999)

“To fly an airplane it must fly ‘in the zone.’ Too slow and
you stall and lose control; too fast and the wings come off.”

This is what Captain Dan Ryder, a former Navy fighter pilot who also served as Underway Command Duty Officer on U.S.S. Nimitz, explained as we sailed around Santa Cruz Island in a 37’ Tartan. That conversation took place the weekend before the “bailout” vote, and it has stuck with me ever since.

Since then world equity markets have plunged in a dive that hasn’t been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world’s economic policymakers has become acute. As stated in this weekend’s Financial Times in a telling quote, “Five years ago central bankers seemed almost omnipotent; now they seem scared.”

No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94—that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago. [Since writing this article, the VIX has hit 80 two times.]

The importance that volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.

Low volatility makes for a difficult environment to write options and capture premium in a risk adverse manner. Like an airplane flying too slow, volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.

Since that date volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs—the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the “sweet spot” or “zone” for premium capture—a VIX ranging between 20 and 30.

This is the average range for the VIX from 1997 through 2003. But to gain insight into volatility spikes during this time period one must look back to three events. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. However, each of these readings is far below a VIX of 70+ reached this past Friday.

More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01. But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan’s takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.

We got our answer on September 14, 2008, when in one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America, while Lehman Brothers filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer. That event set off the domino effect when on September 18th, the Fed provided AIG with an $85 billion loan in return for a government stake of 79.9 percent and effective control of the company—an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system.

It’s been downhill ever since with the largest financial “bailout” in United States history causing an existential crisis amongst those who hold to purest free market ideology. Yet, even with its passage—noting that financial market “rescues” have precedence in U.S. history dating back to Alexander Hamilton—the deterioration in the markets has not stopped (yet, as of this writing).

It is a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets. And last week it seemed that the metaphorical wings of market volatility finally came off.

With the VIX above 50, much less given its rise above 70, market conditions have become extremely imprudent to trade. This is the conclusion that we came to, resulting in our liquidating positions.

Has the options trading model blown up?

Investor interest is options programs is a study in contrarian behavior. During the 1990s there was a great deal of aversion to the strategy of writing options. This began to change after 2003 when the S&P 500 bull market and the VIX bear market provided a “goldilocks” environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.

The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. In order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.

Conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. Then came the subsequent transition to higher volatility since February 2007 which has yet again chastened many investors.

There is an old saying when it comes to options trading—it is like picking up nickels and dimes in front of a steamroller. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short “gamma” as happened during 1998, 2001 and 2002.

So what distinguishes one option program from another, as well as risky trading from less risky trading? The answer is qualitative, but the trick is to produce “risk-adjusted returns,” in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.

First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. The key is risk-adjusted returns.

One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is “theta,” or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.

A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will “white knuckle” their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.

Risk of ruin is high with this kind of approach, and there is a tendency for the “deer in the headlight” syndrome. If traders do cover such positions, thereby booking large “painful” losses, they will often “roll” the contract to another strike price in the hope that the market won’t reach that subsequent level.

This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.

The critical question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.

The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed—one which balances the quantitative with the qualitative in order to manage cycles of volatility.

Traders like to talk about how they provide “alpha” or skill-based returns. Alpha is a byproduct of “beta,” which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as the tactical overlay in response to changing market conditions.

This is the strength of discretionary trading—the ability to tactically adapt to changing conditions.

Unfortunately, the ‘quality of returns’ is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.

Where does option trading go from here?

The seeds of the economic crisis we currently find ourselves is founded on the ‘forward contract exclusion’ from Section 2(a)(1)(A) of the Commodity Exchange Act of 1936. From this loophole in the Act, and various court cases since 1936, as well as the CFTC’s 1992 exemptive order issued under then-chairperson Wendy Gramm, evolved the unregulated over-the-counter (OTC) derivatives market. It is this history, along with deregulation built into the Commodity Futures Modernization Act of 2000, which allowed for the exponential growth of the $50-$60 trillion credit default swaps (CDS) market.

But for the ISDA and its former CEO, Robert Pickle, previous market crises such as the Orange County and Metalgesellschaft derivatives debacles in 1994, as well as the implosion of Long-Term Capital Management in 1998, should have long ago forced OTC derivatives onto exchanges such as the CME.

The persistency of frozen credit market conditions in the face of multiple central bank, treasury and government actions/interventions is cause for great alarm. Meanwhile, the Sword of Damocles overhanging this crisis has always been the CDS market. Draconian as it may be, some are calling for international action to declare credit default swaps null and void. But could this fear be overblown?

Fear culminated in panic last week as the market eyed Friday’s Lehman Brothers CDS auction in New York. The average price at the auction was below 10 cents, and worry was that financial institutions worldwide would have to face a bill of as much as $400 billion leading to significant writedowns.

It turns out, however, that the net payouts that CDS sellers have to make on defaulted Lehman Brothers debt is only a small fraction of the amount of insurance that was written. According to the DTCC, the “multilateral” calculations it performed on swaps tied to Lehman “indicate that net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range.”

This is excellent news as it proves to the market that net exposure on CDS transactions is substantially less than the $50-$60 trillion nominal figure often cited, which in fact references the “underlying” bonds and loans being protected. In other words, contract offsets greatly reduced overall market exposure.

Meanwhile, there has been an announcement that the CME Group will launch by the end of November the first electronic trading platform that is fully integrated with a central counterparty clearing facility for the CDS market. At the same time, the G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.

Nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. At the same time, the cost of protecting Dubai’s debt surged last week as concerns mounted about potential investment losses in the Emirate and the refinancing of up to $22 billion of debt.

Meanwhile, Standard & Poor’s stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the “real economy.” Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.

All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also have been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation.

Current volatility as of today makes any attempt at establishing option positions very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.

So for option traders who survived and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be “in the zone” for these programs.

- Mack Frankfurter, Managing Director

3rd Qtr 2008 Review and Nonno's Mistake

2008-10-02T09:04:00.001-07:00

Moral Hazard and Aggregate Wealth Portfolio

2008-10-02T08:29:00.000-07:00

"His name was George F. Babbitt. He was 46 years old now, in April 1920, and he made nothing in particular, neither butter nor shoes nor poetry, but he was nimble in the calling of selling houses for more than people could afford to pay."
--"Babbitt" by Sinclair Lewis (1922)

The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.

Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.

Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?

In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.

The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”

There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.

What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang (1993) concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.

Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.

It is time for a new economic ideology to take hold which adheres to the middle way. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.

The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.

- Mack Frankfurter, Managing Director

1st Qtr 2008 Review and Atypical Markets

2008-04-29T22:37:00.000-07:00

We Need to Eliminate the Enron Loophole

2008-04-29T21:59:00.000-07:00

Excerpt from my article: "The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns."

"The theories which I have expressed there, and which appear to you to be so chimerical, are really extremely practical—so practical that I depend upon them for my bread and cheese."
— Sherlock Holmes, A Study in Scarlet (1888)

The mysterious case of the commodity conundrum is sure to elicit passionate debate on either side of the equation—is the commodity boom due to speculation or fundamentals?

Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.

To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has caused a self-perpetuating feedback loop of ever higher prices.

In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”

Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly. Nevertheless, the official CFTC stance is that speculative trading is not the primary culprit behind surging commodity prices, but other factors such as the declining dollar are contributors.

Yet, it is undeniable that the physical delivery markets for grains, which require that the actual commodity be delivered against expiring futures contracts, are no longer converging. This is probably just the tip of the proverbial iceberg—it is arguable other hard assets are priced “out of whack” for any number of reasons.

For example, public policy plays a role in pricing issues too. For example, continuous accumulation of strategic oil reserves by multiple governments implies rising support levels. In that sense, speculative pressures can expose “bad” application of otherwise well-intentioned government policies, such as subsidies for ethanol production or programs which pay farmers to take erosion-able lands out of production. All the same, governments’ counter-response to excessive speculation can be unhelpful, and shutdowns of free market activities are occurring.

The problem for the public is that theses issues can be complicated, and in a sound bite society which desires easy answers and easier solutions, the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.

Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.

Fact is, the genie is out of the bottle and it is not going to be put back. But the financial services industry also needs to acknowledge the imbalances it has wrought in the commodity markets. The following sets the record straight...

Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.

Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.

As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.”

The conundrum for financial “investors” is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time. Accordingly, the derivatives and securities markets require two different types of regulation. Why?

The percentage of open interest in futures contracts relative to crop size is out of proportion. For some crops, only 10,000 contracts are needed by bona fide hedgers. For comparison, the year-to-date volume of wheat contracts traded through March 2008 is 5.7 million contracts. Meanwhile, the CFTC requires hedgers to provide large trader reporting, but unregulated participants have no such requirements. Further, there are systemic issues with big moves happening overnight and taking place off-exchange.

This is explained in further detailed in more detail in the complete version of this article (to request a PDF version, email: info@cervinocapital.com).

As a CFTC registrant and participant in the managed futures industry, I am personally baffled at our lack of representation regarding the “closing the Enron loophole” issue. Managed futures represent a class of regulated speculators who have traditionally provided liquidity to the bona fide hedgers. Our role is indispensible to the proper balance to commodity trading because we go both long and short commodities. However, if we do not ensure our place at the table, we may lose our rights if not the viability of our industry.

In effect, the “securitization of commodities,” a difficult topic in itself to analyze given the proliferation of different types of securitized commodity instruments, has led to an undermining of the prime economic purpose of the commodity futures market. The primary benefit provided by futures markets is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge.

Investors must recognize that risk management markets exist primarily for the benefit of bona fide hedgers. Securitized commodity products are not structured to serve that purpose. Rather, this innovation has allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility. Further, they are sold as investments, when in fact these products are speculative.

As discussed in detail in the complete version of this article, the “Enron loopholes” within the Commodity Futures Modernization Act have served to undermine the authority of the CFTC, and put the futures industry as well as the economy at risk. It is time to rein in excessive market speculation which is occurring on the “dark exchanges’ and support the transition of unregulated commodity speculation back into the domain of the regulated futures industry.

The Close the Enron Loophole Act (S.2058), introduced by Senator Carl Levin of Michigan, would rearm the CFTC with the tools needed to subject “dark markets” to the same oversight as traditional futures exchanges. Exempt commodity exchanges would be made subject to the same standards as traditional contract markets regarding position limits, large trader reporting and transparency requirements. The proposed Act would also require large-trader reporting for domestic trades on foreign exchanges.

If a facility for trading commodities looks like a futures exchange and acts like a futures exchange, then it should be regulated like a futures exchange.

At the same time, securitized commodity products should come under regulations similar to that which has been imposed on single-stock futures. Recent events reveal that long-bias commodity index funds and commodity-linked ETFs may systemically represent a form of market manipulation.

If investors are interested in investing in commodities on an unleveraged basis, then the futures exchanges should develop “fully-funded” non-leveraged instruments, similar to mini-futures, for investors to trade.

Further, Series 7 securities representatives should be disallowed from marketing commodity-related investment products without also having a Series 3 license and registration as associated persons.

Additionally, commodity-related securities products should be subject to NFA 4-29 marketing rules as is imposed on futures industry registrants. For example, hypothetical concepts such as the roll return should have attendant hypothetical disclosures as would be required of futures professionals.

As to the institutionalization of financial investments in long-biased commodity positions, index funds need to accordingly recognize their inherent responsibility in financing credit lines to utilities which facilitate physical deliveries of commodities. Admittedly, this may be difficult under current law.

These concerns raise a key question for the futures industry, managed futures, and bona fide hedgers. Why are securities professionals allowed to hold themselves out as commodity professionals? The debasing of this core rule has led to confusion in the public's mind and threatens the futures industry profession, thereby undermining the CFTC's authority as granted by the CEA.

Has there been an abrogation of responsibility by the CFTC? Is this regulatory body now beholden to interests other than the constituents it is suppose to serve and regulate?

A key responsibility of the CFTC is to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation.

The 2006 U.S. Senate Staff Report by the Permanent Subcommittee on Investigations concludes as follows:

“It is critical for U.S. policy makers, analysts, regulators, investors and the public to understand the true reasons for skyrocketing energy prices. If price increases are due to supply and demand imbalances, economic policies can be developed to encourage investments in new energy sources and conservation of existing supplies. If price increases are due to geopolitical factors in producer countries, foreign policies can be developed to mitigate these factors. If price increases are due to hurricane damage, investment s to protect producing and refining facilities from natural disasters may become a priority. To the extent that energy prices are the result of market manipulation or excess speculation, a cop on the beat with both oversight and enforcement authority will be effective.”

Ironically, we’ve been here before... The Commodity Exchange Act of 1936 repeats the same in a more concise fashion, “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery… causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.”

The more things change, the more things stay the same. “Eliminate all other factors, and the one which remains must be the truth.” Perhaps, we can take heart from Sherlock Holmes in “His Last Bow.”

“Good old Watson! You are the one fixed point in a changing age. There's an east wind coming all the same, such a wind as never blew on England yet. It will be cold and bitter, Watson, and a good many of us may wither before its blast. But it's God's own wind none the less, and a cleaner, better, stronger land will lie in the sunshine when the storm has cleared. Start her up, Watson, for it’s time that we were on our way. I have a check for 500 pounds which should be cashed early, for the drawer is quite capable of stopping it if he can.”

- Mack Frankfurter, Managing Director

2007 Year End Thoughts Going Into 2008

2008-01-16T10:47:00.000-08:00

Prepared Speech on the Subject of Volatility

2008-01-16T10:34:00.000-08:00

The following is from a speech prepared by Davide Accomazzo for the quarterly review of the Pepperdine Investment Club, a class which manages real money in a real portfolio.

Let me begin by thanking you for inviting me here tonight; it is an honor and a privilege.

This opportunity you have in running a portfolio with actual money is a great tool to become acquainted with the true meaning of portfolio management. When I took my investment classes in business school, part of the program was to individually manage a $100,000 portfolio for the duration of the class. Whoever had the best performance would win…

Of course, this was not “real” $100,000, which in my case was rather good since after spending about half the class comfortably at number one, I decided to take a leveraged bet on the dollar index just before the U.S. Government shutdown in 1995. From there, I miserably dropped from first place to last place, where I concluded the class.

Later, when I called my professor to tell him that I was going to Wall Street to trade euro convertible bonds for an investment bank, he said, “When I saw you blow it all up with that trade, I knew you were going to go to Wall Street!”

Well… ten years later and after dodging many bullets, with real respect for risk and volatility, and a much better understanding of risk management and discipline, I can say that blowing up that hypothetical portfolio was a worthy experience. Because of this, I would like to touch upon the subject of volatility, and hopefully provoke interest as well as more analysis on your part in your quest to become money managers.

Many years ago, a friend of J. P. Morgan, at the time the most powerful banker and investor in America, if not the world, asked him what his outlook for stocks were for the coming year. The legend states that J. P. answered, “Stocks will go up and stocks will go down.”

Such a seemingly overly-simplistic comment probably disappointed Morgan’s friend but in reality it was the truest analysis Morgan could have given. Even today, with all the advances in quantitative science and the power of technology, the “tea leaf reading” activity in guessing market direction is still, at best, a matter of batting averages and discipline. In other words: stocks will go up and stocks will go down.

What I believe is of utmost importance, and often underestimated, is a clear understanding of the potential violence of those swings; how deep stocks might go down and how high stocks may fly. I am referring to stock market volatility. The process of incorporating volatility analysis and volatility forecasting in portfolio analysis is in my view of paramount importance.

There are many ways to refer to such volatility and one now commonly used benchmark is the VIX, a measure of market volatility calculated by averaging the weighted prices of out-of-the-money puts and calls on the S&P 500 index.

While this benchmark was confined mostly to derivative players for years as an analytical tool, it has recently come to the forefront. I believe that an understanding of how the VIX illustrates and maps market participants’ risk behavior can only improve your portfolio management technique.

There are also lessons to be learned from studying volatility behavior in its historical contexts. One should always be on the lookout for warnings flags as indicated by irrational market behavior—the madness of crowds—as well as disconnections between implied and statistical volatility.

The past is littered with examples: absurdly low volatility levels in 2006, followed by a slew of blow-ups in 2007 including subprime hedge funds, CDO mispricings, and quant hedge funds are recent cases in point. Going just a few years back, there is the 2001-2002 bear market volatility spikes, and before that is the 1998 LTCM volatility convergence trade fiasco.

Consequently, you should imprint onto your psyche the potentially misleading significance of Gaussian calculations in trading, and in turn focus on the importance of volatility cyclicality, the value of common sense, and the need for strategic insurance.

Always ask yourself: Am I being paid enough for the risk I am taking?

Or, on the other side of the coin: Are opportunities undervalued given the market’s structural and behavioral profile, and should I increase exposure?

And always keep in mind the effect of the unforeseen event, now commonly referred to on trading desks as the “Black Swan.” How you can protect your portfolio, or likewise profit from it… because that is or certainly should be, why people pay you to be their money manager.

- Davide Accomazzo, Managing Director

2nd Qtr 2007 Review and Black Swans

2007-07-08T21:25:00.000-07:00

Managed Futures and Incubating Talent

2007-07-07T16:37:00.000-07:00

INVESTING IN FUTURES AND OPTIONS INVOLVES RISK AND MAY NOT BE SUITABLE FOR ALL INVESTORS. THEREFORE, INVESTORS SHOULD CAREFULLY CONSIDER THESE RISKS AND DETERMINE WHETHER THEY ARE SUITABLE FOR INVESTING IN LIGHT OF THEIR FINANCIAL CONDITION AND INVESTMENT OBJECTIVES.

"Managed Futures: A Model for Incubating Talent" was originally published by Focus Point Press, Inc. (Emerging Manager Focus) on June 18, 2007.

“Until lions have their historians, tales of the hunt shall always glorify the hunters.” --African Proverb

The idea of traders staking other traders for a slice of profits is probably as old as trading itself. Fast forward to the late 1970s and one unearths Commodity Corp. which is remembered for launching the renown careers of Michael Marcus and Bruce Kovner. And in 1983 Richard Dennis is legendary for having made a bet with William Eckhardt which led to his recruiting and training the “turtles.”

One of Richard Dennis’ earliest if not first client was Bradley N. Rotter,[1] who established a successful track record by investing early with traders like Joe and Bob Hickey, Willis-Jenkins, Mississippi River, EMC Capital and Hawksbill Capital. In 1990 Rotter founded a company called The Echelon Group with the idea of forming joint ventures with talented traders and then helping them grow into niche money management firms.

Then there is Arpad “Arki” Busson, who began his career raising capital for Paul Tudor Jones and is the founder of EIM Group with $8bn in assets.[2] Busson made his name betting not in stocks, bonds or derivatives, but rather in upstart managers some who became hedge fund titans.

The common thread between these trailblazers is the niche segment of the alternative investments industry they got their start in—managed futures.

Managed futures has always been the little kid brother to the hedge fund juggernaut. Nonetheless its impact upon the industry is writ large in two significant and related ways: first, the managed futures industry unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve.

Money managers within the futures industry operate under registrations either as Commodity Trading Advisors (CTA) or Commodity Pool Operators (CPO). The latter in practice is a regulated hedge fund,[3] but it is the CTA structure we’re most interested here.

Key to the development of any emerging trader is the ability to establish a legitimate performance record and quickly raise assets. Managed futures addresses both of these concerns.

With respect to raising client investments, managed accounts are an established and widely accepted vehicle within the managed futures industry. This arrangement provides a variety of benefits from the investors’ perspective. Advantages include the fact that futures accounts are mark-to-market daily, transparent and easy to monitor, and most importantly liquid in the sense that an investor can easily fire a CTA (as a matter of practice CTAs usually liquidate positions on instruction in 24-48 hours or even less). On this basis it can be argued that the managed account structure is a more attractive vehicle for investors who focus on emerging traders, especially when compared to concerns about hedge funds’ delay in performance reporting (often it is quarterly), lack of transparency, as well as investment lock-ups and redemption cycles.

Sophisticated investors in managed futures utilize what is known as the cross-margin account structure where a cash account is capitalized and collateralizes trading accounts traded on a nominal or notional basis. The result is a customized multi-advisor portfolio with the ability, at least hypothetically, to control the leverage utilized by CTAs that capital is allocated to.

Managed accounts provide several advantages for emerging traders too. The legal, administrative and audit costs in setting up a hedge fund can be prohibitive and requires traders to try and raise at least $5 to $10 million in client assets before they commence trading. Meanwhile, it is not uncommon for CTAs to establish themselves starting with $100k in assets. Minimum account sizes within the industry range from $25k (exception rather than the rule) to $5 million, with smaller minimums making it easier to attract clients.

The other advantage managed futures provides emerging traders—a regulated environment for establishing a money management business—is exactly that aspect which many traders perceive as a major disadvantage. It is in actuality quite the opposite situation.

The Commodity Futures Trading Commission and the industry’s self regulatory organization, the National Futures Association, have set forth clear accounting and disclosure guidelines with respect to CTA managed account composite performance reporting. The rules are also well established in regards to disclosure of client trading versus proprietary trading as well as hypothetical presentations.

There are too many nuances for this article to delve into a detailed examination of certain issues regarding reported CTA performance data. Suffice it to say that the formalized composite methodology and the ability to publicly disseminate composite performance on managed accounts, something which is a significant regulatory constraint for private placements, is a great boon to emerging CTAs in terms of their ability to publicly market their track record.[4]

In fact, the only consistently reported data in the early days of alternative investments initially came from CTAs, not hedge funds. This data became the basis for an academic body of research on managed futures which includes studies by Lintner (1983), Baratz and Eresian (1985, 1989), Oberuc (1990) and Schneeweis (1996).

One can point to the beginning of the institutionalization of alternative investments as partly a result of CTA performance tracking databases such as Managed Account Reports which grew into MAR/Hedge, and TASS Management which is now Lipper/TASS. These organizations, like many focused on managed futures in the 1980s and 1990s, subsequently evolved from boutique businesses to industry insiders within the hedge fund universe.

This returns us to the original idea that managed futures is and has always been a fertile area of the industry for developing emerging talent apart from those with institutional pedigree.

Managed futures remains mainly a boutique shop industry. Start-up costs are relatively immaterial and many CTAs are or began as one-man shops by leveraging proprietary track records, registering with the NFA and filing a disclosure document. Established industry databases collect and present CTA performance via websites such as www.ma-research.com and www.barclaygrp.com. At the same time, there is an established network of Introducing Brokers (IBs) and Associated Persons who focus primarily on marketing CTA programs.

There are pitfalls, however. Due diligence on many of these operations would reveal that they are light on the operational side. While certain administrative activities can be outsourced, it still remains the trader’s responsibility to establish sound practices and comply with the ever-expanding burden of rules and regulations. Yet a trader focused on operations and marketing is not focused on the markets, research and trading.

Another approach to starting up a CTA is partnering with operationally minded personnel that can relieve many of the administrative requirements from the trader’s shoulders.

This is the approach my business partner and I took when we established Cervino Capital Management LLC, a CTA and RIA. Leveraging my background with Rotter in the 1990s incubating emerging traders and then running the operations-side, I co-founded Cervino with Davide Accomazzo. Davide also has prior experience in managed futures previously running a CTA as a one-man operation as well as an offshore hedge fund.

Besides the segregation of duties—Davide is Cervino Capital’s principal trader and concentrates his attention on the markets—development of our trading program began by first considering how we would differentiate our product from competitor programs. We achieved this by creating a well-defined yet robust mandate in which the trading program operates. This was done in view of what we thought prospective clients would desire in terms of various factors including but not limited to performance objectives versus equity volatility, margin-to-equity utilization which allows leverage through notional funding, and a best practices approach to operations.

This is atypical of how many CTAs get their start, and reveals other questions for investors to consider when allocating to an emerging CTA program, including: applicability of proprietary results as representative of prospective trading in client accounts; amount of leverage used to generate returns, serious consideration and commitment by trader as to the program’s capacity limitations; as well as accessibility and organizational professionalism.

Unfortunately, while “past performance is not necessarily indicative of past results,” there is a tendency with many who invest in managed futures to chase hot performance. Rather, what should take priority in investor’s thinking is the robustness of the underlying trading strategy as it pertains to varying market environments—when does an approach work best, when does it not work and how does the CTA manage risk and drawdowns during such periods?

Investors who invest with emerging CTAs (and the same applies to investing in established CTAs) should seek to develop robust multi-advisor portfolios with these questions in mind.

Likewise, if making allocations to emerging CTAs is considered an attractive investment, then what about the business model of incubating CTAs? The economies of scale that derive from leveraging standardized and professional operations with multiple sources of trading talent, has from my experience, always been an attractive opportunity.

- Mack Frankfurter, Managing Director

----------------------
[1] Futures Magazine, “Rotter thrives on investing from the gut” by Staff, February 1991
[2] Financial Times, “To live and dream hedge funds” by Stephen Schurr, March 29, 2006
[3] Report of The President’s Working Group on Financial Markets, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” April 1999
[4] Note: This is not necessarily applicable to CPOs, most which are structured as limited partnership private placements (or other similar entity based on jurisdiction) and if domiciled in the U.S. concurrently operate under the same SEC exemption rules as hedge funds; CTAs, on the other hand, are generally not subject to certain exemption rules which limit marketing to the public because they trade managed accounts.

This article was first published by Focus Point Press, Inc. (Emerging Manager Focus) www.focuspointpress.com. It is republished here by permission. Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program offered by Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.

1st Qtr 2007 Review and Exogenous Risk

2007-04-10T12:19:00.000-07:00

Playing Liars Poker in a Kudlowian World

2007-04-10T07:15:00.000-07:00

“It may well be that the booming American economy is still the greatest story never told. But the reality is that low-tax free-market policies are triumphing here and around the world.”
-- Lawrence Kudlow, host of CNBC’s Kudlow & Company

They say, “don't argue with the tape.”

Fair enough… admittedly we have been bearish of late and conflicted about the potential risks to and outlook for the economy versus equities’ unrelenting upward trajectory. This tension culminated on February 27th when the market hit a wall, bounced after becoming short-term oversold middle of March (expected), and then as of early April almost fully retraced the “correction” without hardly looking back (unexpected).

Not surprisingly, the bottom of this volatile move coincided with the week that Goldman Sachs (3/13/2007), Lehman Brothers (3/14/2007) and Bear Stearns (3/15/2007) came out with their earnings release. It seems Goldman Sachs and gang used the opportunity to declare that the “contagion of sub-prime risk was contained” and it was so.

All the same, Goldman Sachs is not an uninterested party…

Several years ago a variety of investment banks including the ones mentioned above began acquiring ‘sub-prime’ lenders which they historically had regarded with disdain. Thanks to financial engineering, though, these banks were able to get into the sub-prime origination business while at the same time limit their own exposure. They did this by bundling these speculative-grade loans into a Drexel invention called collateralized debt obligations (CDOs). These “derivatives,” which divided the underlying loans into pieces with credit ratings as high as AAA and riskier parts called equity tranches or toxic waste because they are first in line for any losses, where then sold to yield-hungry investors from hedge funds to pension plans. Fees for managers of CDOs can range from 45 basis points to 75 basis points of the amount of the CDO, and so the origination and securitization of these mortgages evolved into a booming business.

Only problem was that these banks still had toxic waste left on their books when things began to unravel. So like any good poker player, my take is that they bluffed to gain time to work out their book, while the market with its multiple institutional players vested to the long side bought into and supported the story willingly. “If you can't spot the fool in the game, it's probably you.” [See here for more on the shenanigans of Goldman Sachs]

So as I write this a little over a month after 2007.15, another in an evolving series of Nostradamus dates predicted by the jailed Martin A. Armstrong, we have increasing clarity on just what market forces are really at play here…

First, the U.S. stock market according to a gauge called the price-earnings ratio is far better valued than it has been for some years. To gain some perspective, a week before the recent bull market began in October 2002, shares of companies in the S&P 500 traded at 26.5 times reported profit. Now, the price-earnings ratio stands at 17.1 times, which is by the way neither cheap nor expensive relative to long-term historical averages.

However, according to the Fed Model stocks are inexpensive relative to bonds. The profits of companies in the S&P 500 Index is growing faster than shares outstanding, and represents a yield of 6.5 percent compared with 4.7 percent for the 10-year U.S. Treasury notes. This gap, the widest since 1986, is encouraging investors because consensus earnings forecasts indicate the U.S. will keep growing, while bond yields have been showing confidence that inflation will stay in check.

In fact, the widening gap between what companies yield in earnings and the cost of borrowing is what sustains company buybacks, mergers and acquisitions, and private equity leverage buyouts. The result is a circular reference or what George Soros calls reflexivity, where the yield on the market is driven up by buybacks, M&A and LBOs thereby reducing share float and increasing earnings yield, which then in turn encourages more borrowing to finance the same because of the widening gap between companies yield in earnings versus the cost of borrowing. So as long as earnings yields stay north of financing costs, the theory goes that there will be a wall of corporate buyback and private equity money looking to turn any sell-off into a buying opportunity.

The problem with the Fed Model is that the lower yields go, the higher the implied value of stocks, even while the economy slows. This is why any weak economic data is a signal for investors to rally the market, and goes to explain the myopic focus on the probability of the Fed cutting rates later this year despite economic data showing indications that inflation pressures are still present.

In the meantime, any positive economic data is also treated as constructive because it is supportive of continued profit growth and diminishes the concern of a recession due to the housing slowdown. Effectively, we’re in a goldilocks environment the bulls argue.

The second significant market force is the global economy…

Another saying goes, “if the U.S. sneezes, the rest of the world catches a cold.” Countries including China, Japan and Germany run large trade surpluses with the U.S., supporting the assumption that a pullback in American demand will hurt their growth. But lately developing nations are becoming less dependent on the U.S. because of stronger demand in other industrial nations, making the world’s economy more “resilient.”

Germany's economy, which as recently as 2005 was derided as the “sick man” of Europe, grew by 2.7 percent in 2006. Germany is Europe's biggest economy and after Japan the world's third-largest in terms of gross domestic product. Germany’s growth points to elements of a broader and deeper sustained growth in Europe which exists independently of the U.S. economy.

At the same time Japanese consumer spending is showing signs of picking up as Japan’s economy, which has been battling against deflationary pressures for some time, extends its longest expansion since World War II with business confidence near a two year high. Recent indications of a pickup in personal consumption will also help to offset slower export growth in the face of a possible slowdown in the U.S., Japan’s largest market.

Emerging markets such as China and Brazil are also coming to the fore with consumer and capital spending last year growing at twice the rate of developed nations. Also the Persian Gulf states including Saudi Arabia and the United Arab Emirates are investing billions of dollars gleaned from higher oil prices, much of it reinvested locally in an effort to restructure their countries into more diversified and self-sustaining economies.

With the IMF predicting that world GDP will increase 4.9 percent this year, the fourth straight year above 4.5 percent and the best performance since 1980 when the IMF started keeping records, it is looking like most countries are in a position to “decouple” from the U.S. economy and sustain strong growth through a U.S. slowdown. This would reverse the trend of the past five U.S. recessions, when 3/4ths of industrial countries suffered downturns due to a slump in the U.S. economy.

Ironically, it is demand from overseas that is throwing a lifeline to America. And the lower dollar is helping. With exports accelerating and imports shrinking, trade this year may add to growth instead of subtracting from it for the first time in more than a decade.

Still, even though the importance of the U.S. economy has diminished, there are still dangers of “spillover” from a slowdown in the world’s largest economy because so many companies and investors in the rest of the world have ties to American businesses and markets.

So what are the major risks that Wall Street is weighing as we start the second quarter of 2007?

Perhaps the surest ticket to a bear market in stocks would be for Americans to close their wallets, either because they’re spent out or because they’re nervous about their finances or their job outlook. Investors have no recent experience with a consumer-led recession as the last one was 17 years ago in 1990. The 2001 recession, by contrast, was led by a plunge in business outlays. Since consumer spending accounts for more than 2/3rds of U.S. gross domestic product, the economy could go into a deep freeze.

Another risk is that corporate earnings shrink. Wall Street is fully expecting a slowdown in profit growth this year with a weaker domestic economy, but an outright decline in earnings might come as a shock. While the price-earnings ratio now stands at 17.1 times, if earnings fell and the price-earnings multiple were to rise the market would perceive stocks as more costly.

Finally and probably most importantly, there is concern about the dollar. The U.S. economy has been built on foreign money over the last two decades as massive inflows of capital from overseas have been needed to cover the nation’s trade and budget deficits. Other countries’ savings is what underwrites our spending.

This is where things get dicey…

High U.S. rates compared to countries like Japan which has resulted in the carry trade help support the dollar’s value. If the U.S. economy were to weaken and the Fed were to cut rates, the result could be a steep plunge in the dollar, which in turn could spark inflation by raising prices of the imports U.S. consumers crave. If inflation rose, the Fed presumably would have to go back to tightening credit which likely would cause a revaluation of stocks as the Fed Model goes into reverse mode.

This is where I see the Fed being caught between a rock and a hard place given the current economic balance that has been achieved here and abroad.

As things stand now, the Fed can neither raise the target rate because that would further tighten liquidity in the credit markets and likely push the U.S. into a consumer-led recession by further harming the housing market, the effects of which would eventually be felt globally; nor can they lower rates because such a move might cause the dollar to decline precariously stoking inflationary pressures while at the same time chase away foreign investors from our Treasuries for other higher-yielding currencies such as the Euro—this in turn would also cause U.S. long-term rates to go up.

As the world’s reserve currency since the Bretton Woods Agreement in 1944, the U.S. Dollar has enjoyed the enviable position of the most important international currency. Up until WWII, the British Pound had been the major currency by which most others were compared. Presently, however, due to structural problems with the ongoing problem of trade and budget deficits, sustainability of the Dollar as reserve currency of the world has increasingly come under question.

Interestingly, the economic conundrum we find ourselves in now is similar to concerns raised in the early part of the 20th century. In his book The Economic Consequences of the Peace (1919) John Maynard Keynes wrote:

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

It may be controversial if not sacrilegious to reference Lenin, but consider the following debate by these two media pundits…

On one hand you have Lou Dobbs, anchor and managing editor of Lou Dobbs Tonight which attracts CNN's largest audience of about 800,000. Originally a classically conservative economist, Dobbs' views have changed over time, and he is now a strong critic of the “excesses of capitalism,” which he identifies as globalization, offshore outsourcing, illegal immigration, free trade deals, corporate/big business influence in government and the Bush administration's tax cuts. A populist for “main street America,” he warns that the erosion of the American dream is being facilitated by political agendas in Washington that are controlled by big business and special interest groups, or worse just “plain” incompetence.

Dobb’s uses several bylines to highlight his points: “Exporting America,” “Broken Borders” and “War on the Middle Class.”

Then you have Lawrence Kudlow, a supply-side economic commentator and host of Kudlow and Company on CNBC. He opposes estate taxes, as well as taxes on dividends and capital gains, advocates that employees be compelled to make greater contributions to their pension and medical costs (suggesting that these expenses are an undue burden on corporations), defends high executive compensation and opposes most forms of government regulation. He believes that reducing taxes will increase revenue, and in general, supports a smaller government that does less and citizens who take more individual responsibility. He advocates wide ownership of stocks and is what we would call a populist for the “investor class.”

Kudlow’s catchphrase is that “the booming American economy is the greatest story never told.”

So who is right? In my mind both arguments have merit but the answer to this dichotomy may rest with Keynes too…

The Marshall Plan after Second World War is a similar system to that proposed by Keynes in The Economic Consequences of the Peace. The Marshall Plan was a massive spending program adopted by the United States after World War II to rebuild war-torn Europe and Japan. In a similar fashion, James Paulson of Wells Capital Management has theorized that the chronic U.S. trade deficits of the last fifteen years represent a similar Marshall Plan aimed at jump-starting and stimulating the development of emerging economies. Indeed, total emerging consumption is now slightly more than one-half U.S. consumption and the U.S. consumer is no longer the sole locomotive for growth.

This is a big positive because new consumption leadership is emerging where the standard of living needs to be raised most. But meantime the cost is a depreciating Dollar.

The argument over whether the standard-of-living in the U.S. has declined or not for the average American due to these large external forces is unclear to us. What is obvious is that there is more than ever an “arbitrary rearrangement of riches” due to the extreme levels of leverage being used to finance this great experiment called globalization.

In effect, Lenin was on to something. The process of wealth-getting for many middle class Americans has degenerated into a gamble and a lottery—overheated home equity appreciation in the last few years being just another example.

- Mack Frankfurter, Managing Director

December 2006 Review and Year End Chat

2007-01-10T11:18:00.000-08:00

THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

As we begin 2007 and close the curtain on 2006, our first year of trading for Cervino Capital Management LLC, we look back at a year of many accomplishments:

- robust and positive performance – our Diversified Options Strategy program was up 0.46% for December and 10.35% for the year

- steady growth of assets under management

- established test investment portfolios in Master Limited Partnerships and Closed End Funds that exceeded S&P 500 returns

- an increasingly important role in the investment community stressed by speaking engagements on matters of finance at various academic institutions, and articles published in investment magazines and on websites

These accomplishments, however, are no reason to rest on our laurels as we recognize that the path to trading success is arduous and unpredictable. Year-end, on the other hand, is a good opportunity to make an introspective review our trading and risk management philosophy and approach. Interested investors should note that the best place to begin a thorough review of our trading program, associated risk factors and specific risk management strategies is our disclosure document. What can better be discussed here is the broader context in which our trading operates.

Our core philosophy is based on the principles of modern portfolio theory which states that, the addition of an uncorrelated asset with a positive expected return to an existing portfolio will increase that portfolio's risk-adjusted return.

While past performance is not necessarily indicative of future results, Barclay Group reports that our correlation to key indices (based on monthly returns Jan. - Dec. 2006) are as follows: S&P
-0.03, EAFE -0.18, Barclay CTA Index -0.32, and US Treasury +0.53. Within the context of a diversified portfolio of stocks/bonds and based on our correlation numbers and positive returns to date, an allocation to our program this past year would have likely enhanced the efficient frontier of the typical stock/bond portfolio.

At the same time proper diversification of trading styles is important when seeking to construct a robust multi-advisor managed futures portfolio. This is a complicated subject made much more difficult by the intricacies of standardizing/comparing performance records and risk/return profiles. Jack Schwager (of Market Wizards fame) wrote an excellent book on the subject we highly recommend called "Managed Trading Myths & Truths" which delves into various factors related to the evaluation of Commodity Trading Advisor (CTA) performance and the potential pitfalls and issues when comparing a CTA's performance with other CTAs or industry indices.

Below are some broad risk/return considerations when comparing our program relative to other CTA programs, and within the context of a multi-advisor portfolio:

1) Generally speaking we believe a good risk-return profile for CTAs is one that over the long run can consistently generate 2.5 to 3 times positive return relative to subsequent drawdowns. For example, a CTA that generates 30% return should manage peak-to-trough drawdowns to no more than 10%, and so on. Given that our fully-funded return objective is 10-15% annually, we designed our options program with the intent of keeping peak-to-trough drawdowns between 3-5%. That said we cannot guarantee that we can always contain drawdowns as such, and there is ample risk as better explained in our disclosure document for substantially greater loss.

2) Trading futures is less than a zero sum game; for every winner there is a loser plus commission. The key question is who in the futures market is taking money from whom (hedger, speculator)? What's the trader's "edge" (blackbox, scalper, etc.)? What type of market does the program best operate: choppy, trending, high volatility, low volatility, time horizon?

When putting together a multi-advisor CTA portfolio it is important to try and combine trading programs that are non-correlated and smooth out overall portfolio volatility. For example, a potential complimentary match is a trend following futures program with our program which often trades options on a contra-trend basis. While our options program may underperform a trend following program for any particular period, it is likely to outperform when markets are choppy or at turning points, thereby helping smooth out the portfolio's overall returns as this is most likely when trend following programs have difficulty.

3) The high degree of leverage in futures and options can work both for you as well as against you. Unfortunately many investors involved in managed futures are geared toward chasing "hot returns" without due consideration as to the risk/leverage that was utilized to generate outsize returns. It is a common tendency for many new CTAs to start out with strong proprietary or first year returns that quickly attract assets but also set up return expectations that are unsustainable over the long run, especially when assets substantially increase and capacity/liquidity constraints become an issue.

When we developed our Diversified Options Strategy the goal was to design an absolute return type program that reflected conservative performance utilizing a 15-45% initial margin/equity range. Rather than leveraging up performance in an effort to quickly attract assets, we sought to establish a program with reasonable and sustainable risk/return expectations. We think that is best done by setting specific performance goals and margin constraints, and then allowing investors to adjust leverage of risk/returns through notional funding.

4) In order to properly compare multiple CTA track records one has to take into consideration the cost structure (commissions, trading velocity, management/incentive fees, interest, etc.) reflected in the actual performance of each CTA being evaluated, as well as the respective "model trading levels" including leverage utilized (margin/trading level) to generate returns. Unfortunately, "model trading levels" are not standardized from CTA to CTA. Moreover, as margin/equity ratio is a misleading indicator of value at risk, standardizing the performance measurement of risk adjusted returns becomes complicated, especially when option trading is involved and time decay and probabilities are factors.

Most investors fail to recognize the nature of the returns they are analyzing; in many cases returns are just a function of leverage and higher risk rather than “alpha” or in layman terms the component of return generated by a trader’s skill. If not for the mechanism of price arbitrage with the underlying cash asset, as well as the insurance premium bona-fide hedgers are willing to pay, the returns that speculators in futures generate should largely be a function of skill or “alpha.” For previous generations of professional futures traders profitable trading opportunities were more easily exploitable. But now the playing field is increasingly competitive and a trader’s “edge” is more likely to be linked to a particular systematic approach that does well under certain market environments.

Options on the other hand are wasting assets linked to probabilities of an event risk. For the most part, premium writers can “allow time to do the heavy lifting” in producing returns. The trading model for pure option writers is simple, easily repeatable and generally profitable provided that again certain favorable and consistent market conditions prevail.

To a sophisticated investor we are restating the obvious. But this is where we believe ourselves to be differentiated from the majority of other CTA option programs which from our analysis tend to be one-dimensional and systematic in their approach…

Market conditions are constantly changing, bringing along with it new unforeseen risks. Regardless of instruments traded, we believe that what investors are ultimately hiring us for is our trading skill; that is, the skill in being able to recognize and adapt to different market conditions, readiness to exploit opportunities as they arise, and most importantly the flexibility to manage associated risk. With that perspective in mind, the question we constantly ask ourselves when working to adapt and refine our trading is whether we are increasing “alpha” or just leveraging risk exposure in order to enhance returns.

Paradoxically, a flexible and adaptive trading approach needs to be integrated within a disciplined trading/risk management framework, which for our program we have outlined below:

A) Unlike most other CTA option programs that focus only on the SP, Cervino trades a diversified portfolio which includes equities, currencies, fixed income, agriculturals, energies and metals. We routinely studies in excess of ten markets (SP, EC, JY, CL, GC, SI, NG, C, OJ, US, SB, HG) and our program is typically engaged in active trading on an average of 3-4 contracts.

By performing market analysis across a variety of asset classes and underlying contracts we expose our program to increased profit opportunities as well as diversify risk exposure. Additionally, we can observe the interplay between contracts and their fundamentals thereby placing ourselves in a better position to identify “viral” market risks.

B) Because options include directional, time decay, volatility and probability characteristics, various multi-dimensional strategies can be established on any single underlying contract simultaneously thereby diversifying opportunity and risk exposure further. For example, we may have on the SP between 3 and 6 different option positions/tactics in play at any particular time each with different opportunity objectives and risk profiles.

Effectively, the trading strategies we deploy are designed to capture returns in several ways, including but not limited to: (i) replicable relative value spread positions with the intent of capturing premiums; (ii) fundamentally based trades involving a directional trend bias that can be deployed through either long or short option positions, or debit or credit spreads; and (iii) opportunistic volatility plays that take advantage of option under- or over-valuations as well as trend reversal/mean reversion opportunities.

C) Our trading methodology allows for regular adjustment of positions as material shifts in market conditions may warrant. From a risk management perspective this is an advantage over many CTA systematic option writing programs we have analyzed and who typically rely on the probability that their routine option positions will expire worthless. But as a result, our program may have higher commission costs than other option programs.

What should also be noted here is the fact that the option markets have become increasingly efficient. Because we are “upstairs traders” and subject to bid-ask spreads, commissions and other costs/constraints such as market liquidity, our trades are essentially positional in nature with time horizons ranging from 2-3 weeks to 3-6 months. This increased efficiency has also impacted, but to a lesser degree, option floor traders/scalpers as bid-ask spreads have become tighter.

D) Most of the investing public harbor misunderstandings about the mechanics and risks associated with options as an investment tool. We typically establish option positions out-of-the-money where the probability that the underlying goes into-the-money is a major consideration. Such positions will start out with a reduced delta exposure relative to the underlying futures contract; in other words, a point move in the futures contract will result in a reduced directional movement in the options contract.

This is one of the important ways in which we manage account volatility. It also explains why the majority of our daily equity swings tend to be in the 10-40bps range, and why our program’s volatility is generally much lower than that of CTAs who focus their trading mainly on futures.

That said, the main risk concern with respect to short option positions is managing positions when either a trending market evolves against a strike price or an abrupt exogenous event occurs and option writes convert to a futures equivalent exposure. This is why when we write options or credit spreads our trading focus becomes keyed on risk management stewardship.

On the other hand the same above scenarios (trending market, exogenous event) work in favor of long option or debit spreads, assuming it is in the same direction as the established position; which is why when appropriate we encompass those tactics within our portfolio approach too. Alternatively, risk is inherently limited in long option or debit spread positions.

E) Another important underpinning in our managing risk is achieved through position sizing adjusted according to account size, volatility and risk-reward analysis. Generally we adjust positions sizes to $50k levels, and sometimes we refine risk exposure by changing the traded strike. Additionally, we may choose to increase or decrease position size/leverage based on our confidence level in a particular trade. And with delta neutral type strategies (strangles, condors, etc.) we may skew contract quantities to one side or the other.

F) Risk control is also achieved through money management rules and the utilization of stops (see Section 3.10 of our disclosure document for a discussion on risks associated with the use of stop-loss techniques). Occasionally we may adjust positions either by entering into new positions which hedge existing market exposure, or by liquidating/covering existing positions in order to reduce market exposure, or reset a position at a different strike price and/or contract expiration. For example, we may lift one leg of a credit spread to take advantage of a trending market, then “roll-up” and reestablish the credit spread at a higher level.

G) Lastly but just as importantly, what lies beneath our trading framework/methodology as outlined above, and what ultimately triggers trading decisions, is a blended analytical process combining quantitative analysis, fundamental studies, and technical and sentiment indicators. Our disclosure document goes into more detail on this aspect and should also be refer to for a more complete description of principal risk factors associated with our Diversified Options Strategy, something which cannot be adequately addressed in this piece.

When all is said and done, we feel that our approach is unique among many of the other CTA option programs. Our trading encompasses a core disciplined methodology yet allows for the application of multi-dimensional trading strategies depending on perceived market conditions, opportunities and related risk. The result is a program that is not static but dynamic and focused on increasing alpha rather then leverage in order generate consistent risk-adjusted returns.

This piece would not be complete without a macro-level analysis of the current market environment as that reflects in option valuations and by extension our program.

As indicated above, implied volatility is central to any option program and a key factor in the risk associated with collecting premiums. A review of our program's performance shows that three of our best four monthly returns in 2006 were during June, July and August. This is not by accident but reflects a period when implied volatility in the S&P 500 (as measured by the VIX) was at its highest for the year. At the time we were exploiting a premium capture strategy. Conversely, it is transition points in market volatility such as in May when the S&P first began its correction that indicate periods of greater risk to existing option write positions.

October and November 2006 has also been a period of high risk for option writers but for different reasons, specifically the strong trending stock market and imploding volatility. In fact, the VIX hit lows not seen since January 1994.

Sellers of options during this period have had to either increase their positions and/or place their selected strikes closer and closer to the underlying price in order to collect the premium/maintain the returns they have historically generated; or alternatively they have had to reduce risk and accept lower returns by selecting option strikes that are more in line with historical price standard deviations. Our response to this extreme market environment has been to shift more of our tactics to purchasing options through debit spreads. For that reason November ended up being our strongest month with a Euro debit spread position we put on the prior month working strongly in our favor as the contract rallied.

To emphasize this point here is a link to a chart going back to 1990 showing the S&P and VIX (the link also provides an interesting esoteric piece about the construction of the VIX). The chart clearly shows that from 2003 to present volatility has been steadily declining. Given the three year bull market in the S&P and the bear market in the VIX, the chart makes obvious in hindsight the reason for the performance/success of CTAs who just write puts on the S&P.

Our aim here is to illustrate that different trading approaches work best in different market environments. During the late 1990s, breakout and trending markets were a rarity in commodities and therefore trend-following programs generally suffered.

For option programs, however, return potential is not a function of markets going up or down, but of implied volatility which has recently evaporated. The time of greatest risk (as well as profit potential) for option strategies is when implied volatility diverges from mean historical volatility, which happens to be the situation now.

This raises two questions: first, is this trend in low volatility here to stay, or is it just a short-term phenomenon and we eventually return to a period when the VIX averages between 15-25; and second, how prepared are the plethora of option programs that have come into existence in the past few years set up to manage risk in a potentially different market environment in the future.

When all is said and done, we believe our primary job to be sensitive to risks and manage them when they arise. Backed by our many years of professional experience in the managed futures industry, we strive to be the “thinking man’s trader” and deliver for our clients a conservative yet robust trading approach that is a value-added augmentation to an investor’s total portfolio.

In conclusion and given that it is the beginning of a new year, we would like to try our hand at predicting the future and review a few elements we think will become part of this year’s strategy.

Continuing along the line of the last comments, we believe that 2007 will show increasing volatility across a number of markets: equities, dollar, possibly bonds. Volatility in crude oil should remain high and it should increase again in gold albeit not as high as this past spring. As stated in previous pieces, we still expect a recession sometime next year courtesy, among other factors, of a further decline in the housing market. Energy will prove to be a good buying opportunity after the recent declines and should a recession indeed occur and depress oil further we will look to accumulate the commodity.

Having said that, we endeavor to think flexibly and trade the markets as they evolve in real time. We will always strive to be agile enough to never act as if we are smarter than the market, and use prudence when constructing profitable positions with the benefit of our clients in mind.

We wish you a prosperous new year!

- Davide Accomazzo, Managing Director
- Mack Frankfurter, Managing Director

The Mysterious Case of Massive Liquidity

2007-01-09T21:37:00.000-08:00

“Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”
— Sherlock Holmes, The Adventure of the Abbey Grange (1904)

Professionals in the markets are more suggestible than a layman might imagine. Try as we might, we can never know the one thing we really want to know—that is, the future. Not knowing, we compare notes with others. Most are brave together at the tops and meek together at the bottoms.

As we finished 2006, the general consensus was that the latter half was spurred by a wave of global liquidity with U.S. and European stock markets gaining double-digit returns, and the emerging markets doing even better. Alongside the liquidity came a remarkable fall in volatility with the CBOE’s VIX index (known as the “fear gauge”) falling to 13-year lows in November and December.

All was rosy as strategists at twelve of the biggest Wall Street firms agreeing that U.S. stocks will rally in 2007. With everybody lining up in the bull camp, however, Davide and I are a little nervous about the market’s complacency—ironically the last year Wall Street strategists were this rosy was in 2001 when the S&P 500 Index dropped 13%.

Assuming that Bernanke has maneuvered us into a “soft-landing” and we are in a “goldilocks” economic environment, what could go wrong?

Based on last year’s actions by Goldman Sachs when they poached Lachlan Edwards, one of Europe’s financial restructuring gurus, the “smart money” is gearing up for a credit crunch—that is, a reversal of the liquidity tide that investors find themselves floating on. History shows that when mass scale restructurings occur, they tend to do so very rapidly like tsunamis—often triggered by an unexpected economic downturn or political shock.

Our main job as money managers is risk management. Looking forward we try to best assess where potential risks may come from. If the concern is about liquidity and the credit markets, then we need to understand how this sanguine market environment came about.

Monetarists such as Milton Friedman, who recently passed away at age 94, believed that “money supply” was the key to the ups and downs in the economy. Further, he thought that the Fed's sole job was to "expand the money supply in a steady manner by 3% per year."

The Greenspan legacy, however, is for the Fed to intervene in the markets strategically during times of financial crisis. He first did so early in his career back in 1987 when the Fed added heavy doses of liquidity to arrest the stock market crash. Then there was the expansion of money supply in the weeks leading up to the end of the 20th century when the so-called Y2K computer bug was expected to disrupt financial systems. Lastly, in response to the 2001 recession Greenspan lowered overnight rates to a 1958 low of 1 percent resulting in record mortgage refinancings that minimized the recession. Intervention, rather than being a brief rescue effort, seems to have become a permanent policy.

Another wave of stimulus came from the 2001 and 2003 “Bush tax cuts.” There are two ways in which tax cuts can stimulate growth—in the near term by generating extra demand, and in the long run by encouraging increased supply, labor or capital. Add to this the 108th and 109th Congress gone-amuck earmark spending as well as the increased military budget to finance two wars (the Iraq war now is estimated to have cost $350bn so far and is still costing $7bn a month), and the combination of monetary and fiscal stimulus in the first half of this decade set the stage for a tidal wave of liquidity.

The overhang of fear resulting from the 2001-2002 bear market also contributed to the current environment as money gravitated from the stock market into “safe assets” such as government and agency bonds. This in turn drove down interest rates on the long end of the yield curve which further lowered borrowing costs, and functioned to help corporations get their balance sheets in order as well as support real estate prices upwards through the 2001 recession.

Effectively, lower interest rates led to a boom in home buying which caused real estate prices to double and triple in some locations. One result was owners taking advantage of their increased home values in the form of mortgage equity loans. The impact was not insignificant on the economy. According to Calculated Risk, GDP as reported for the last six years has appreciably improved as a direct result of home equity withdrawals, a trend that first began in 2001. The process of incurring debt collateralized by an inflated asset is similar to margining a securities brokerage account as stock prices go up, the result is additional liquidity and leverage.

Because of inflated home valuations the use of exotic mortgage products such as ARMs, I/Os, etc. increased from very limited usage to approximately 50 percent of the mortgages used to finance homes in California. The seriousness of the potential fallout is not lost on the Federal Reserve Board and the Office of Thrift Supervision who recently came out with warnings regarding "payment shock," essentially “margin calls,” associated with sharp upward adjustments of a loan's interest rate after initial low-rate discount periods on exotic mortgage products. Such payment shocks are expected to increase substantially in 2007 and 2008.

In addition, the Center for Responsible Lending just published a report suggesting that 2.2m American households could lose their homes and as much as $164bn due to foreclosures in the ‘subprime’ mortgage market. To put this report into historical perspective, at the peak of the credit boom in the 1930s, home mortgage loans were offered without the usual documentation, a practice that in the last few years has again become enormously popular through so-called “stated income,” “low-doc” or “no-doc” loans. Stated income loans, originally conceived to improve access to prime credit for self-employed people with irregular income, has spread like a virus down through the lending industry, where it is a virtual invitation to fraud.

Credit fraud is a liquidity multiplier. The link between fraud and liquidity is documented by several white papers in relation to international banking. A paper written by Dr. Wimboh Stantoso, Senior Researcher at the Directorate of Banking Research and Regulation Bank Indonesia, points out that the 1998 Pacific Rim currency crisis resulted in the Indonesian government revoking permits on 16 private national banks whose “sources of problems for those banks were mainly illiquidity and insolvency as a result of credit defaults, fraud and liquidity mismatches.” Another paper by Jean-Claude Berthelemy on “Financial Reforms and Financial Development in Arab Countries” writes about non performing loan (NPLs) and “cases of fraud and liquidity problems faced by the banking sector” in regards to bad debt with a delay of servicing over one year.

The topic of NPLs brings us overseas to the shores of China. China is dealing with a mountain of bad loans—how much is the question. In May 2006 Ernst & Young reported that NPL exposure for China was estimated at US$911bn, but subsequently withdrew the report. According to the China Banking Regulatory Commission, as of the end of the third quarter of 2006, the total number of NPLs in China’s commercial banks was approximately US$160bn. However, this amount does not include NPLs that are presently held by foreign investors such as hedge funds that have been on a buying binge in Chinese distressed debt. Based on the 1999 transfers that investors have resolved, the implication is that E&Y’s NPL estimate is not miscalculated. The main inference, however, is that these NPLs represent a significant liquidity multiplier and risk.

China’s economy, in the meantime, is on track to grow by more than 10 percent for the third year in a row. In November 2006 China reported that its foreign currency reserves, the world’s largest, had exceeded $1,000bn for the first time. China has effectively outsourced its monetary policy to the U.S. resulting in talk of pressure from the incoming Democratic Congress in the form of “currency manipulation anti-subsidy laws” to persuade China’s government to revalue its currency. Even Fed Chairman Bernanke stepped into the fray with his remarks branding China’s undervalued currency an “effective subsidy” for exporters that was distorting trade. At the same time, China’s monetary policy committee complained that the main responsibility for this imbalance lies with the U.S. Treasury printing too much money. The upshot is that a fundamental change in reserve allocation/diversification away from the dollar is taking place and not just with China.

The subject of dollar imbalances brings us to the so-called Japan carry-trade. With the Bank of Japan keeping rates pegged to a measly 0.25 percent, this bubble has been ballooning in which people borrow cheaply in yen and then invest in higher-yielding assets abroad. The economic effect is again similar to leveraging your brokerage account with margin, except that this is taking place on a global scale with hedge funds leading the way. Concern is that a sudden flowback of yen, such as what happened in 1998 when the yen went from Y140 to the dollar to Y110 in just two days, could trigger financial chaos as far abroad as Iceland and India. Even the U.S. is not immune as some market participants blame the limited unwinding of the carry-trade that occurred in April 2006 as initiating the sharp decline in the stock market in May 2006.

Another liquidity multiplier is all the petrodollars that have been created with oil prices rising from the $20-$30 range to $78 dollars as of August 2006. Last year will be remembered in the Middle East for Iraq’s tragic slide into sectarian conflict and Israel’s miscalculated? war in Lebanon. Less noticed, though no less dramatic, has been the oil-fuelled economic boom in the Gulf and a surge in financial liquidity that has been transforming the face of the region. Oil wealth translates into political advantage on the world stage as petrodollars are deployed and recycled in the local region and abroad. The key question is whether oil producers can turn this boon into a lasting opportunity and create more robust economies that can sustain themselves through periods of low oil prices. Referring once again to reserve diversification, Russia and Opec have reduced their exposure to the dollar and shifted oil income into euros, yen and sterling.

But more interestingly has been the proliferation in the issuance of “sukuk” or “Islamic bonds.” Usury in Islam is prohibited, but banks today are adopting methods to get around this by combining Islamically permissible contracts to produce what is effectively interest-bearing loans. The effective result is not only the leveraging of petrodollars, but the evolution of an Islamic monetary system similar to modern Western banking system which had historically evolved from the practices of European goldsmiths in the 17th century. Back then, the receipts issued and backed by deposits of gold coins on deposit for safekeeping with goldsmiths transformed these merchants into money-lenders who manufactured “bank money” on such receipts, giving rise to the concept of money supply.

Money supply creation is no longer something constrained to banks, but now something that is easily produced between two parties through derivatives trading. When Greenspan took over the Federal Reserve Bank much attention was focused on gauges of money supply defined as M-1, M-2 and M-3. Disregarding the debate on the importance money supply as a reliable measure and indicator of future inflation, a new type of money supply which I've coined “M-0” has increased explosively alongside the growth of derivatives since the early 1990s. "M-0" is the “notional” valuation associated with a derivatives contract; that is, for example, the difference between the $250,000 nominal face value of an S&P futures contract and the $25,000 actual cash required to trade the instrument. The definition of financial leverage is liquidity magnified. Derivatives, while very effective as a risk diversifier, also has had the effect of leveraging asset values throughout the economic system.

And round and round it goes—the examples of liquidity expanding throughout our global monetary system are nearly endless. Many would argue this is all good and point to how robust the world economic landscape has been in the last few years as globablization has spread. And on an encouraging note, the World Bank recently hypothesized in a report that if growth around the world continues at about its current pace, by 2030 the number of middle-class people living in developing nations will triple to 1.2 billion.

However, the problem with liquidity is that it is like an addictive drug—initially it produces euphoria which then disappears with increasing tolerance. Once an economy is hooked it needs more and more in order to sustain itself and withdrawal can be difficult.

Key to the creation of liquidity is credit. “Credit” is a financial term with a moral lineage. Its first meaning is “debt.” John Locke once wrote “Credit is nothing but the expectation of money, within some limited time.” To credit is to believe, and to lend money it is necessary to trust someone. Yet, financial history is rife with periods when prolonged prosperity wore down the skepticism of creditors only to result in eras of economic hardships.

The riddle is whether the central banks have succeeded in breaking the cycle, not the inflationary cycle which in fact it has enthusiastically subsidized, but the deflationary cycle. Has the sheer bulk of global liquidity forestalled the kind of contraction that paralyzed business activity in the depression and demoralized speculative activity for a generation after that?

I started out this piece by asking what could go wrong…

Sudden economic downturns are typically instigated by event risks from unexpected places. Looking at the tea leaves we’ve identified several areas of concern:

The price of oil this past week has dropped to $55. A further implosion in the price of oil would undermine a major source of revenue for countries who produce this commodity. The recent windfall has allowed such nations to build foreign reserves and improve the quality of their debt resulting in lower interest rates and helping drive an infrastructure investment binge. This could unwind if investors begin to pull money from emerging equity and debt markets resulting in an increase in interest rates. In this scenario, the combination of reduced oil revenue and higher interest rates would cause infrastructure projects to grind to a halt triggering a global recession.

Another area of concern is geopolitical risk where mismanagement of monetary and fiscal policies spreads to other markets. For example, the Asian financial crisis of 1997-98 began in Thailand with the devaluation of the baht. Recently Thailand’s newly minted military government stumbled badly by imposing capital controls. Such controls demonstrate a poor grasp of such action’s consequences. In a world where China, Japan, Taiwan, South Korea, Russia and Singapore control two-thirds of the world’s reserves, we find ourselves exposed to these nation’s monetary or fiscal policies. Who knows where its starts: a miscalculation by China’s central bank in its efforts to manage excess liquidity could trigger a global recession, or the Bank for International Settlement’s Basle II standards forcing new hedge fund investment rules in Japan may trigger widespread redemptions there and an unwinding of the carry trade.

A third concern is that the U.S. economy will in fact grow as expected, but the markets come to realize that growth rate is in fact not so great. Analysts close to the Fed believe most policymakers now see U.S. potential growth as being between 2.5-3 percent, a decline from the 3-3.25 percent range commonly cited a few years ago. Many private sector analysts interpret a decline in productivity growth as likely to put upward pressure on inflation and interest rates. Given that the U.S. stock market is “fairly valued” at earnings ratios based on record productivity levels, if corporate earnings cool off the stock market could begin to melt down. Add to this an economy fueled by leveraged loans and looser lending standards, S&P warns that a sudden change in appetite from investors could force banks to absorb large leverage loans on to their own balance sheets. This in turn could cause a re-pricing of credit risk resulting in higher interest rates causing the economy to spiral downward.

Then again, perhaps given the enormous attention to the riddle of liquidity in the financial press, this is all but a tempest in a teapot—economists can’t seem to agree whether there’s too much or too little. As so eloquently said by Sherlock Holmes, “My dear Watson, there we come into those realms of conjecture where the most logical mind may be at fault.”

- Mack Frankfurter, Managing Director

November 2006 Review and a Volatile World

2006-12-09T13:04:00.000-08:00

The Lore and Legend of the Bulls and Bears

2006-12-07T18:40:00.000-08:00

“Nothing is more admirable than the fortitude with which millionaires tolerate the disadvantages of their wealth.”
— Rex Stout, Mystery Novelist (1886-1975)

After gold was discovered at Sutter’s Mill in California, instant wealth was for the taking and all across America men made the decision to go west. Many sought and some found fortune in a camp called Hangtown, which at that time rivaled San Francisco.

Among the diversions sought by the miners on a Sunday afternoon was the bullfight that had long been a part of California’s development under Mexican rule. The bullfight, which had been introduced to Spain by the Moors in the 11th century, was brought to Mexico by the Spanish and was part of the fiesta held regularly at the mission-presidio complexes established between 1536 and 1832. The Mexicans added a wrinkle of their own by arranging fights between Spanish bulls, first brought to the new world by Columbus, and the native grizzly bear that roamed the California coast.

The Spanish longhorn cattle were brought to Mexico in quantity in 1521 and virtually ran wild until Texas became a state in 1845. The longhorn had a keenly developed sense of survival and often encountered the grizzly in the wild.

The game that entertained the miners in Hangtown was to chain a 1,000-pound grizzly to a huge stake in the middle of an arena and then turn the bull into the same arena. The fights were short and violent with the bull sometimes winning by impaling the bear, but mostly the bear won by meeting the charge between the horns and using his enormous paws to wrestle the 1,500-pound bull down to the ground, often breaking its neck in the process.

Since the gold discoveries created a flood of trading in mining shares, both in San Francisco and New York the terms “bull” and “bear” were introduced in the investment jargon to describe opponents in setting market direction. The analogy had been used before by the Spanish writer Don José de la Vega in 1688, but the active Civil War markets established the terms for all time.

The first person to be called a bear or bull was Jacob Little, who made his mark by introducing short selling in the panic of 1837. He made and lost four fortunes in the years that preceded the Civil War and was dubbed “The Little Bear” by fellow traders. One time he escaped a corner in Erie Railroad by buying convertible bonds that had been sold in England, unbeknown to the bulls, and he converted the bonds to cover his short position.

The two combatants that focused the terms for all time were the bear, Daniel Drew, and the bull, Cornelius Vanderbilt. The analogy fit perfectly the gigantic struggles between these two titans that went on for 30 years over steamboats and railroads.

Vanderbilt was as straightforward and optimistic as a bull, while Drew was devious, without scruples, and always trying to wrestle the market lower. These two bumped heads continually with a fight over Harlem Railroad during the Civil War producing a typical encounter.

Vanderbilt had been accumulating shares of the road for a number of years and introduced improvements to the line. Uncle Daniel was attracted when the stock started to move and joined in the buying to give the price an artificial boost from $8 to $100. He then cooperated with the politician “Boss” Tweed to mount a massive bear attack on the road. They went heavily short the stock, and Tweed used his influence to get Harlem’s right-of-way rescinded.

Vanderbilt let them “operate” until the stock dropped to $72. They had sold 137,000 shares, even though only 110,000 shares were outstanding. Vanderbilt then began soaking up the shares held by others and advanced the price to $179, forcing the bears to terms with the Commodore.

But then Drew attacked again, selling the stock down to $100 before Vanderbilt began to squeeze again. He raised the price to $285 and offered to settle again. Drew, hat in hand, pleaded with the Commodore and was finally excused with a $500,000 loss.

Vanderbilt advised Drew, “After this, never sell what you haven’t got, Dannie.” Which prompted Dan’l to compose his famous couplet, “He who sells what isn’t his’n, must buy it back or go to prison.”

In the gold camps, the bear defeated the bull in most fair fights. On Wall Street, the smart money follows the bull. Daniel Drew died broke, unable even to fulfill pledges to his church (he was short there too!), while Commodore Vanderbilt left his son William a fortune of $80 million——the only son he didn't disowned because he was as ruthless in business as his father and the one Cornelius believed capable of maintaining the business empire.

- Mack Frankfurter, Managing Director

October 2006 Review and the Perfect Storm

2006-11-04T19:12:00.000-08:00

What Ever Happened to the Loyal Opposition

2006-11-03T10:03:00.000-08:00

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.”
— Sir Ernest Benn (Publisher, 1875-1954)

As I write this, there are only four days left until the mid-term election—it cannot come soon enough.

And so, with some trepidation, and despite our blog’s focus on economic and investment concerns, I am allowed, this once, at the risk of alienating certain readers, to banter in political discourse and comment on that which should not be discussed amongst friends.

Let me begin by first addressing the pollsters and ideologues who feel it necessary to categorize Species Americana Voter and box us into political affiliations and “liberal” or “conservative” leanings—I recently reregistered for “Other” writing in the Whig Party.

[The Whig Party existed from 1832 to 1856, and was formed to oppose the policies of President Andrew Jackson and the Democratic Party. In particular, the Whigs supported the supremacy of Congress over the Executive Branch and favored a program of modernization and economic development.]

This is just another way of saying I’m an Independent without inadvertently becoming associated with the American Independent Party, a party with a specific platform I do not entirely agree with.

But seriously, I’m in total agreement with Will Rogers when he said: “The more you read and observe about this politics thing, you got to admit that each party is worse than the other. The one that’s out always looks the best.”

And so there you have it; per chance you may even agree: something is rotten in the state of U.S. politics, as it seems all has become fair play with our representatives’ desire to win at any cost. That cost is getting very, very expensive, and I’m not just talking dollars.

Spreading hatred and lies about one’s opponent has become a routine and accepted part of running for office. According to factcheck.org, a respected website that reviews the accuracy of ads, this year stands out for the sheer volume of personal assaults.

No wonder some of the most intelligent and capable people in our country don’t want anything to do with politics.

Watch CNN, MSNBC and FOX regularly, and you cannot but admire the skill of punditry that permeates dialogue on all issues and even non-issues. Hyperbolic, distorted and divisive rhetoric is the rule along with blatant bias in anchors’ “reporting.” Guests with the loudest retort are implicitly declared the debate winner, notwithstanding any obvious hypocrisy in a particular “expert’s” positioning of “truth.”

Sure, it makes for good TV. But the next thing you know Rolling Stone is declaring Comedy Central’s Jon Stewart and Steven Colbert America’s most trusted “news anchors,” as a reprieve from the likes of FOX’s Sean Hannity and Bill O’Reilly, whose self-declared authority on everything under the sun conjures up a McCarthy-era redux of mistrust toward our fellow Americans.

Yet this malady of cynicism is not particular to our times. Davy Crockett (1786-1836) is quoted as saying “There ain’t no ticks like poly-ticks. Bloodsuckers all.”

Fact is, I’m mad as hell and I’m not going to take it anymore.

What we need is a return to the center. We need to quiet the shrillness emanating from the vocal minority and replace it with intelligence, moderation and mutual respect.

Unfortunately, the current trend in American politics is not encouraging in this regard.

A French economist by the name of Frederic Bastiat once suggested that when social policies turn out to be harmful to the citizenry, it is because politicians often react to problems that they can see, without any regard for the unforeseen consequences of their solutions to those problems.

Mark Twain also had a thesis about politicians and wryly wrote circa 1882 “Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

No doubt both Twain’s and Bastiat’s sentiments apply to the 109th session of Congress.

Regardless of the outcome in the House or Senate races, there are many serious issues that need to be addressed. The biggest dirty little secret everyone in Washington knows is the budget deficit.

Politicians don’t like to talk about the nation’s long-term fiscal prospects—the subject is complicated and it reveals serious problems and offers no easy solutions. This is not a partisan issue. But the problem is tied to the country’s three big entitlement programs: Social Security, Medicaid and Medicare. At the same time, the burgeoning cost of the war in Iraq is not helping matters.

Fortunately for us there are true patriots like David M. Walker, head of the Government Accountability Office (GAO), which makes him the nation’s accountant-in-chief. Walker’s job is not in jeopardy if he tells the truth (he is serving a 15 year term ending in 2013), and what he has to say is scary.

Washington has dug itself a fiscal black hole. Combine that with the “demographic tsunami” that will come as the baby boom generation begins retiring with the recklessness of borrowing money from foreign lenders (such as China) to pay for the operation of the U.S. government, and you’ve got a recipe for disaster. Not facing this issue, squarely and honestly, will irreparably damage our great country for future generations to come.

Given the current climate I have little hope anything meaningful will be accomplished in the next two years unless the rhetoric is toned down and replaced by sensible dialogue between those with contrasting positions. Worse would be another session of Congress that kowtows to the President and legislates without transparent and meaningful debate.

Luckily, voting anti-incumbent is a great American tradition. The focus should be on electing politicians who are willing to work more than three days a week and forge bipartisan solutions, not engage in endless fund raising and political upmanship.

However the election manifests itself, given the current state of affairs, what we need most is new leadership in Congress and a return to principles of mutual respect.

Long live the loyal opposition!

- Mack Frankfurter, Managing Director

September 2006 Review and Buying the Bull

2006-10-04T17:44:00.000-07:00

Options: A Three Dimensional Chess Game

2006-10-04T17:40:00.000-07:00

"Could we look into the head of a Chess player, we should see there a whole world of feelings, images, ideas, emotion and passion"
— Alfred Binet (French Physiologist, 1857-1911)

One of my favorite pastimes is playing chess, which unfortunately I have not had the time to indulge as of late. To experience the full brunt and emotional psychology of the game try a five minute speed match against a chess hustler in Washington Square Park, NYC. Unless you’re rated 1800+ you will likely walk away feeling beat-up.

Don’t believe me? Bobby Fischer, the only US-born chess player ever to win the World Chess Championship, once said “Chess is like war on a board. The object is to crush the opponent's mind.” Even more revealing is what he said during a Dick Cavett interview, “I like the moment when I break a man's ego.”

For the uninitiated the inner nature of this multidimensional game is nicely explained by David Norwood in his book Chess and Education:

“It is often supposed that, apart from their ‘extraordinary powers of memory,’ expert players have phenomenal powers of calculation. The beginner believes that experts can calculate dozens of moves ahead and he will lose to them only because he cannot calculate ahead so far. Yet this is utter nonsense. From my own experience I can say that grandmasters do not do an inordinate amount of calculating. Tests, notably de Groot’s experiments, support me in this claim. If anything, grandmasters often consider fewer alternatives; they tend not to look at as many possible moves as weaker players do. And so, perversely, chess skill often seems to reflect the ability to avoid calculations. It is, in truth, not clear that chess is a game of calculation. Of course there are times when intense calculation is called for, and often the master is better at dealing with these situations than the amateur. No wonder, he has had more practice than the amateur, but all the same his innate calculating ability need not be any greater. Most of the time it is something quite different that is required, something akin to ‘understanding’ or ‘insight.’”

Interestingly, the analytical yet intuitive nature of chess and trading is very similar, and many great traders happen to also be fanatical chess players. In fact, the introspective process is so alike that Norwood’s description could have been written about trading.

The psychological aspect of trading is something that serious investors should spend time studying. Generally, investors have three choices when trading an asset directly:

(1) stay out of the market
(2) buy and “go long”
(3) sell and “go short”

Once either “long” or “short” the next decision becomes whether to stay in the position or get out; technically this is known as “liquidating the long” or “covering the short.”

The confluence of investor agendas results in historical market prices which can be tracked by charts. Anyone who has looked at charts can easily recognize markets that trend up or down versus markets that move sideways within a range. Charts are great tools, but don't forget they look backwards. As the regulators regularly remind us “past performance is not necessarily indicative of future results.”

From an emotional perspective such tactical investment alternatives, seemingly simple trading decisions, present an array of contexts. Remaining un-invested is neutral, but psychologically the trader is thinking in terms of greed or fear: “Should I stay out or get in? Is the reward worth the risk? What if I buy it here and it goes lower? Is it too expensive? What if I wait for it to go lower before buying?”

Common sense wisdom says “buy low, sell high,” but how many investors feel more comfortable “buying high, selling higher?” Unfortunately, most of the time we end up buying high and selling low, emotionally trapped by the “come back to breakeven before selling” curse. Chartists call this "resistance" because investors sell at these levels, while "support" levels exist because there are no more sellers as investors are willing to hold until a better price.

Purchasing an asset is the easy part; alas most investors don’t think about an exit strategy. The “trend is your friend until the trend ends,” but how far should you let a stock “run” before you sell it? How would you feel if you sold it but then it goes up further? What if it was higher, but now lower… Would you wait until it goes back up? What if it doesn’t go back up? What if it goes lower still? At what point would you feel forced to sell?

Thomas Huxley, known as "Darwin's Bulldog" (1825-1895), once quipped that “The chessboard is the World, the pieces are the phenomena of the Universe, the rules of the game are what we call the laws of Nature and the player on the other side is hidden from us.” The same sentiment could easily be applied to trading.

As you can see, there are many emotional dimensions to just buying and selling an asset. And when a trader has the sophistication to “go short” the thought process doubles.

This psychology underpins every day decisions/actions of markets participants. Quite a few books analyze the phenomena such as the 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay. Successful investors learn to discipline their emotions and act contrarian to natural tendencies.

Yet when all is said and done, for most investors the choice is simple: stay out of the market, go long at a certain price, go short at a certain price, or get out at a certain price (liquidate the long or cover the short). As with chess there is vast complexity behind such decisions, but in the final analysis the rules to game are simple.

Not so with derivative trading! If directly trading an asset is like playing chess, then as my business partner likes to say “option trading is a three dimensional chess game.”

An option is a contract whereby one party (the holder or buyer) has the right, but not the obligation, to exercise the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer pays a premium for such right.

Because options are indirectly related to the underlying asset and have many more components for an investor to consider, the result is an unlimited variety of ways to structure trading strategies as compared to just buying or selling the asset.

● First, options are a wasting asset and therefore have a time component. If not "in-the-money" at expiration, they're worthless.

● Second, part of their value is determined by the relationship of the underlying asset’s price versus the option’s “strike price.” The degree of correlation between the pricing of the asset and option is a function of the distance between the asset price and strike price.

● Third and fourth, there are multiple options representing different strikes prices—this is called an "option series"; further, there are multiple expiration dates for each option series.

● Fifth, their price, while related to the underlying asset’s price, is also tangentially influence by the underlying asset’s volatility.

● Sixth, double up all of the points above because there are two basic types of options: “calls” which give the holder the right to purchase the asset at a certain price, and “puts” which give the holder the right to sell the asset at a certain price.

● Seventh, double up everything again because option traders can either be purchasers of options or sellers (“writers”) of options.

So how do all this option background work together in forming three dimensional trading strategies?

Suppose the S&P 500 is trading in a narrow sideways range and volatility is extremely low. Bullish and bearish sentiment is equal and you think that the market is going to breakout either to the upside or downside—but your not sure which way.

If you were trading the Spyder (ETF contract that is linked to the S&P 500 index) you could either go long and hope the market goes up, go short and hope the market goes down, or stay out of the market all together. Limiting yourself to three choices could be frustrating.

But with options you could purchase both a call and a put at the same time. Since your cost is limited to the premium of the option you have limited downside either way if the market rallies or crashes. But if the market does breakout to the upside or downside you will be positioned to take advantage of that move. The key is that you don’t have to be right on the direction—your betting both ways at once.

Now buying options can be expensive, so how do you pay for the right to be a holder?

Let’s say that in the above scenario you think the market is going to go up or down, not in the next month, but maybe three months from now. You could “write” options (both calls and puts) with a nearer expiration date to help pay the cost for purchasing options (both calls and puts) with a later expiration date.

With this situation you’ve got four different positions operating at the same time on the same underlying S&P 500 index. Each of these positions will increase and decrease in value differently depending on the price action of the underlying S&P 500 index.

The above two option strategies are just a sampling of the position combinations that can be created with options, thereby expanding a trader’s tactical repertoire exponentially.

But take note, because of the volatile nature of markets, the purchase and granting of options may involve a high degree of risk. Option transactions are not suitable for many members of the public. Such transactions should be entered into only by persons who understand the nature and extent of their rights and obligations, and of the risks involved in option transactions.

As you can imagine the variety of trading strategies that options offer are limitless and multidimensional. It is that variety that attracted Cervino Capital Management to develop its Diversified Options Strategy. For more information this investment program, visit our website at www.cervinocapital.com.

- Mack Frankfurter, Managing Director

August 2006 Review and Shifting Norms

2006-09-06T19:46:00.000-07:00

They're Just Mad Enough To Be Mountebanks

2006-09-03T02:05:00.000-07:00

'There is nothing so impossible in nature, but mountebanks will undertake; nothing; so incredible, but they will affirm.' As truly might he have added, that there is nothing mountebanks can undertake, which John Bull will not think possible; nothing they
can affirm, which he will not believe.
— Dr. John Gordon, 'The Doctrines of Gall and Spurzheim', 1815

I recently attended a brilliantly marketed event held at a certain hotel. The costly mailer advertised that several Genuine MILLIONAIRE Experts including a certain celebrity would share the “secrets and strategies” to creating wealth. One of their testimonials touted:

“I’ve almost tripled my portfolio in the last 11 months from just under $1M to over $2.7M. Thanks!”

While archetypal of claims made on late night infomercials, financial professionals are well aware that the Investment Advisers Act of 1940 prohibits advisers from making misleading statements or omitting material facts. In particular, "false advertising or mis- representation includes the use of testimonials or endorsements which is prohibited." This bears repeating... THE USE OF TESTIMONIALS OR ENDORSEMENTS IS PROHIBITIED.

My curiosity piqued, and so I decided to investigate this "once in a lifetime" celebrity symposium. Who were these guys, what were they promoting, and how were they able to skate by industry regulations?

The definition of a charlatan is a person practicing quackery or some similar confidence trick in order to obtain money or advantage by false pretenses. Unlike a conman, he does not try to create a personal relationship with his marks, or set up an elaborate hoax using roleplay. Rather, charlatans resort to quackery, pseudoscience, or some knowingly employed bogus means of impressing people in order to swindle victims by selling them worthless nostrums, goods or services that will not deliver on the promises made for them. The word calls forth the image of an old-time medicine show operator, who has long left town by the time the people who bought his snake oil tonic realize that it does not perform as advertised.

Could it be that these guys are the modern day equivalent of financial snake oil operators?

Before conveying what transpired, let me emphasize that the majority of the professionals I know, from insurance agents and financial advisors to professionals in related fields of accounting and estate planning, behave honorably and in the best interests of their clients. Additionally, there are ample regulations in place as well as industry watchdogs and administrative bodies imposing strict guidelines pertaining to its members’ conduct and ethics.

All the same... “Caveat emptor”

Unfortunately this age-old piece of wisdom raises the pragmatic question of how such advice should be put into practice. The answer is twofold: first, educate yourself; second, follow the money.

Most (but not all) financial products are commission-based, that is why the economic foundation and core culture of many brand name commercial banks and brokerage houses rests in their sales force. Yet all because financial products are packaged and sold, it does not automatically make such investments “bad” for the consumer. The question is whether the traditional product-driven, commission-based sales culture that permeates the financial services industry best serves the interests of investors?

As investors have become more educated and less inclined to be “sold” financial products, there has been a transformation in the financial services industry. Have you noticed that there are no more “stockbrokers” or “insurance agents”? Financial product salespeople have evolved into “Vice Presidents,” “Private Bankers,” “Estate Planning Specialists,” Financial Planners,” and all manner of intriguing and captivating titles denoting trustworthiness, wisdom, experience and financial acumen. These titles—they may be well earned and deserved—are meant to boost professional credibility, and to provide consumers with confidence that they are being advised rather than sold, which may or may not be reality.

Fact is that the majority of stock and bond market “advisors” are commission-based “registered representatives,” which is their official regulatory title and indicates that they are agents of their employers (broker-dealers), and are registered and licensed (Series 6 or 7) to receive commissions for the sale of securities (stocks, bonds, etc.). Ludicrously, the Series tests are not at all difficult to pass, and bragging rights often go to those with the lowest passing scores because they are “most likely to succeed”—I am not kidding.

In effect, registered representatives are distribution agents for broker-dealers—it is their job to sell products to the investing public, for which in turn they are paid a percentage of the commission. The percentage a registered representative receives is dependent upon the trailing level of “production” (ie, sales) that he or she generates for the firm. That’s why broker-dealers refer to their agents as “producers” and every representative’s goal is to become a “top producer”. As in any sales culture, compensation is the ultimate benchmark used to measure effectiveness—not the performance of clients’ accounts. A top producer ranking means that he or she is among the biggest generators of sales commissions for the firm and is among the highest compensated agents.

The untarnished truth is that the majority of well-known brokerage firms (also known as wirehouses) push new advisors to sell, sell, sell and only pay lip service to the building of a financial practice with the clients’ best interest in mind.

But I digress… What were these "celebrity" get-rich-quick experts selling? The answer is half truths wrapped in a ‘one size fits all’ motivational pitch designed to push all the right “greed” buttons and get you to buy their snake oil. And the crowd was gobbling it up!

Looking sharp in an expensive business suit and carrying the swagger of a just retired football quarterback, our first presenter was selling a website that provided systematic buy/sell entry/exit points for “only $8,000”. Showing charts with well known and commonly used indicators such as MACD, RSI and stochastics he illustrated on two huge screens presentations of back-fitted trades all perfectly aligned to make money at every twist and turn of the stock. He went on to claim that “these technical tools can help you [us] make a 95% annual return, which over twenty years can turn a $5,000 investment into over $3 billion dollars!! Now, wouldn’t you [us] all like to make a billion dollars?” He extolled to the whoops and applause of a roused audience. So as to nail it home, this charismatic and authoritative speaker was willing to offer us the whole package at a reduced price of just $3,000 including a two day seminar required to make attendees overnight experts on his website system.

I was amazed to watch a large group of the attendees flock to the back tables and happily plunk down $3K knowing that armed with this man’s “secrets” (and their remaining $5k from the $8k “actual cost”) they too will turn into multi-millionaires. Unfortunately they didn’t realize that this so-called “knowledge” about systematic trading is well documented on the business bookshelf at their local Borders Bookstore. And as far as all those charts and indicators on his website, these services can be easily obtained without charge on multiple websites not to mention that most brokerage firms now provide excellent trading portals with an abundance of similar tools.

Of personal interest was the regulatory loophole that allowed this mountebank to use unsubstantiated testimonials—technically he was only selling “investment education” and access to a website. And because he positioned himself as an “educator” and not an advisor, he did not have to be registered. At the same time, while websites providing specific buy/sell investment advice given should be a regulatory cause of concern, my suspicion is that his firm side-step this issue by having their subscribers input their own buy/sell rules based on the two-day seminar each must attend. What was most devious about the slideshow was that the so-called systematic entry/exit points shown were back-fitted and selectively presented. There is not enough room here to go into the development of robust trading systems, but I’ll relay to you what the National Futures Association (NFA) has to say about this:

HYPOTHECTICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOVLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNT FOR IN THE PREPARATION OF HYPOTEHTICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Next was a Juris Doctor appropriately bespectacled to substantiate his intellectual lawyerly demeanor. Just as polished and motivational as the prior speaker, his pitch began with C-Corps. According to him every single one of us was losing out on all sorts of tax deductions and needed to immediately establish our own C-Corp using his easy-to-use book of forms (for only another few thousand dollars, I might add). What about having legitimate business income? “Well aren’t you all going to make big bucks with that trading system you were just shown,” he taunted, “that’s legitimate business income!” Then without skipping a beat he was off and promoting Charitable Remainder Trusts as if this structure was appropriately suitable for each and every attendee.

Now there is no doubt that such structures in certain situations can be beneficial. But the operative words are “appropriate” and “suitable.” For some J.D. who isn’t even a practicing attorney in the State of California to be flatly suggesting that we ALL could benefit from his one-stop-shopping advice made my stomach crawl.

But wait, there’s more! The third expert was about to speak about the “safest, most lucrative, investment strategy in America”—tax liens. To learn everything I needed to know to set myself up only would cost me only another “measly” $3,000. I had enough... I could go on about tax liens as I was once responsible for winding down a portfolio of tax liens purchased from Kidder Peabody by the investment boutique I worked for, but I think my point is made.

So what is to be learned from all this?

Savvy investors know that good investment results requires the steady and persistent application of knowledge, hard work and prudence. Obtaining outsize returns can only be generated by outsized risk—sophisticated investors understand how to measure risk in relation to the returns their portfolio generates. They also ensure that their portfolio is well diversified across a variety of trading strategies as well as asset classes, and monitor the markets and make tactical adjustments as necessary. In order to do this properly institutional and sophisticated investors delegate portfolio management to money managers who have expertise in specific investment strategies.

I hear a lot of criticism about the financial services industry and us professionals in the business—some is deserved, but more often criticisms reflect a level of confusion about investments in general. Yes, it helps to be familiar with the structure of the financial services industry, the sales culture that it propagates, and how your advisor is being paid. But if your not comfortable with investing on your own, that should not prevent you from seeking help to create a personal financial plan and structure a well diversified investment portfolio.

So whether you invest on your own or work with an advisor(s), the key to successful investing is education, diversification and disciplined approach(es). When using a professional seek out advisors who take the time to communicate the costs, risks and benefits of their investment approach. Reputable advisors encourage the public and their clients to become ever more knowlegable about the investment process and risk-return concepts, as that translates into the ability to advise on sophisticated strategies.

Postscript: What about the celebrity? Who was he? Without naming names, it’s enough to say he was a participant in some reality TV show. Like I said, half-truths…

- Mack Frankfurter, Managing Director

July 2006 Review and the China Factor

2006-08-06T10:32:00.000-07:00

Relative Performance vs. Absolute Returns

2006-08-01T18:53:00.000-07:00

"And so instead of absolute places and motions, we use relative ones; and that without any inconvenience in common affairs; but in philosophical disquisitions, we ought to abstract from our senses, and consider things themselves, distinct from what are only sensible measures of them." invest in cervino capital management invest in cervino capital management invest - Isaac Newton, 1687

It seems simple but knowing whether a portfolio manager is doing a good job can be a challenge. It's difficult to define what good is because it depends on how the rest of the market is performing. For example, in a bull market 2% is a horrible return. But in a bear market, when investors are down 20%, just preserving your capital would be considered a triumph. In that case 2% doesn't look so bad.

Absolute return is the fixed percent an asset or portfolio returned over a certain period. Therefore, the 2% mentioned in the paragraph above is considered absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return.

Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark or index such as the S&P 500. Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. For example, if the absolute return of your portfolio is 10% and the performance of the S&P 500 during the same time period is 6%, then you have a relative return of 4% greater than the market (10% - 6% = 4%). If, however, during this same time period the S&P 500 returns 15%, then you have a relative return of -5% (10% - 15% = -5%).

Why is relative return so important? Because it is the generally accepted method for measuring the performance of actively managed portfolios, which should get a return greater than that of the market. After all, you can just buy an index fund that has a low management expense ratio and will proxy the market’s return. However, if you’re paying a portfolio manager to perform better than the market and the investment doesn’t have a positive relative return, it may be worth finding a new manager or just buying an index fund.

But this is where it can get complicated. Who is to say what the “market” is? The S&P 500 index is often cited as the benchmark for the U.S. stock market but in actuality it represents mostly large capitalization stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States, while the Lehman Aggregate Bond Index is comprised of fixed income securities to simulate the universe of bonds in the market. Relative return can also be used within a context smaller than the entire market. For example, a technology fund's performance could be measured or benchmarked against other technology funds. What about foreign stock markets? Have you heard of the FTSE, DAX, Nikkei, or All Ordinaries? These benchmarks represent stock indices for London, German, Japanese and Australian equities, respectively.

It’s wise to look at relative return to see how an investment's return compares to other similar investments. The trick is finding a comparable benchmark in which to measure your investment's return; then make a decision of whether your investment is doing well or poorly. That said, in the final analysis, the power of compounding is best accomplished with consistent positive returns year-in/year-out regardless of market conditions. Investors re-learned this fact after the 2000-2002 bear market, and this is why so many institutional investors have substantially increased their allocations to absolute return programs.

Realizing that traditional methodologies may not be sufficient in helping achieve investment goals leads to the problem of finding absolute return strategies. In order to accomplish this sophisticated investors have increasingly embraced a new paradigm that rejects total return as the measure of a strategy's worth. The concept is that any strategy's total return can be divided into a market return (beta) and 'ideally' a net excess return (alpha). What is of real value is an investment strategy's ability to consistently generate alpha.

The bottom line is it is not easy to find strategies that consistently generate risk-adjusted excess returns. For example, investors must be able to distingish market returns (beta) from excess returns resulting from skill-based actions ("true" alpha) and excess returns resulting from non-skill-based actions (e.g., consistently holding large cash positions, taking increased benchmark risk, or using leverage). Even when one is knowledgable about these performance evaluation concepts, the investor must have access to alternative investment managers (many have high minimums and require "accredited investor" status), be comfortable with the structure, and after making an investment, monitor existing managers to ensure their approach continues to provide desired alpha.

The greatest barrier to acceptance for this investment approach is often psychosocial: the unwillingness to try something new based on frequently cited "conventional wisdom" that is marketed by an industry riddled with conflicts of interest, not to mention regulators and regulations that end up institutionalizing "good" from "bad" investment approaches. The herd mentality always tends to rule. Luckily, innovative investment strategies, such as those offered by the regulated approach called managed futures or unregulated vehicles known as hedge funds, are increasingly becoming accepted as a desirable means for diversification. (In the opinion of this author, hedge funds should be regulated but not the investment strategies they promote.)

The move to the new paradigm of alternative investments, absolute returns, separation and recombination of beta and alpha requires that investors think differently about the investment process and their investment portfolio. No one is claiming that investors should rush to embrace this new paradigm. Instead, they should carefully evaluate this shift to determine its benefits and risks. This understanding will alow investors to develop a prudent plan so they can properly respond to new opportunities.

In conclusion, the separation and recombination of beta and alpha is only one of the fundamental principles of the new investment paradigm. The other, the acceptance of alpha-based strategies as a part of an investor's asset allocation policy is equally important. The search for alpha is difficult, especially when the source of alpha is the asset class itself, such as with managed futures. The key objective for investors is to distinguish manager skill from market returns and factor in investment management costs; that is, pay minimal fees for beta, and only pay for uncorrelated alpha.

The Diversified Option Strategy of Cervino Capital Management is an example of an absolute return program where returns are derived primarily from skill-based trading decisions. While past performance is not necessarily indicative of future results, the program has been able to sustain consistent positive monthly performance since inception as well as very low correlation when compared to the S&P 500 index. Positions are diversified across various financial and commodity markets, and entail complex option strategies that have varying degrees of market direction exposure: long, short or neutral. A key part of this strategy is recognizing that options are a wasting asset. Accordingly, the trading model is similar to the insurance business model whereby premiums are collected and risk management is the primary focus. For more information, visit www.cervinocapital.com.

- Mack Frankfurter, Managing Director

June 2006 Review and Inflation Concerns

2006-07-08T16:36:00.000-07:00

Ways to Diversify Your Investment Portfolio

2006-07-01T20:03:00.000-07:00

"Behold, the fool saith, 'Put not all thine eggs in the one basket' which is but a manner of saying, 'Scatter your money and your attention' but the wise man saith, 'Put all your eggs in the one
basket and... watch that basket.'"

- Mark Twain, Pudd'nhead Wilson, 1894

A well embraced tenant of prudent investing is to diversify your investment portfolio among different types of assets which may respond differently to various economic conditions. Diversification is an effective risk management tool in helping reduce investors’ exposure to a downturn in any one sector.

Notwithstanding the spirit of truth in Pudd'nhead's maxim, a sentiment echoed by Warren Buffet who once said "Wide diversification is only required when investors do not understand what they are doing," proper diversification is a proven method to improve the long-term probability of upside performance as well as downside risk exposure. The key is knowing how to diversify properly. In this blog we delve deeper into the concept of diversification to present the importance of allocation among uncorrelated assets as well as investment strategies.

The term “asset class” describes a group of securities that shares similar risk and return characteristics such as: cash equivalents, fixed income, and equities. Additional diversification can be achieved by blending different categories contained within each asset class. For example, equities can be divided into large-, mid- and small- market capitalization stocks; economic sectors such as energy, healthcare or technology; geographic regions (domestic vs. international); or investment styles (growth vs. value). Fixed income is typically separated into groups designated by the type of issuer, credit quality and maturity.

Beyond asset class distinctions there are several approaches to investing which require differing levels of active management based on assumptions about the investor’s risk tolerance and changes in market expectations. Popular forms include the “buy and hold” strategy in which an investor determines an initial allocation and then holds this portfolio throughout market fluctuations without making adjustments. Another approach is “strategic asset allocation” which requires the investor to make periodic adjustments to restore the portfolio to the targeted mix. And then there is “tactical investing” where the investor actively changes investments to reflect his or her own shorter-term capital market expectations.

An ongoing debate among investors is the extent to which asset class exposure is the primary driver of risk and return, versus to what extent does an active/tactical approach to investing play a positive, negative or neutral role in managing risk and return.

The demise of the unprecedented 1980s/1990s bull market in equities left many sophisticated investors disputing the case for a pure “buy and hold” strategy. Based on institutional demand for hedge funds, these investors have established their growing interest in investment alternatives, particularly “absolute return” programs that generate “alpha” or skilled-based returns that exceed the performance of the financial markets.

Since the late 1970s certain savvy investors have taken advantage of an array of alternative investment approaches vis-à-vis a niche strategy called “managed futures.” These sophisticated investors realize that superior traders operating in this specialized universe offer an outstanding tradeoff between risk and return. They are attracted to the incremental and often non-correlated returns that such investment can provide beyond exposure to traditional asset classes or investment strategies.

Academic research and a growing body of investment theory has shown that assets should be compared on a risk-adjusted basis (e.g., mean return/standard deviation) and that the potential benefit of adding an asset to an existing portfolio may be measured by an asset’s excess breakeven return. Because the correlation between managed futures and most traditional investments is extremely low, when portfolios of traditional assets are combined with managed futures, the result is a reduction of risk (i.e., standard deviation) to the overall portfolio.

Growth in investor demand for managed futures products indicates appreciation of the benefits this strategy can add to a diversified investment portfolio. However, it should also be noted that there is a high degree of leverage that is often obtainable in futures trading that can work against you as well as for you. Because the risk of loss in futures can be substantial, you should carefully consider whether such trading is suitable for you in light of your financial condition.

- Mack Frankfurter, Managing Director